Public Disclosure Authorized
Public Disclosure Authorized
Public Disclosure Authorized
Public Disclosure Authorized
ReportNo. 17554-LAC
OECSFinancialSectorReview
May 27, 1998
Finance, Private Sector & Infrastructure Unit
Caribbean Country Management Unit
Latin America and the Caribbean Region
U
CURRENCY EQUIVALENTS
Currency Unit: Eastern Caribbean Dollar (EC)
EC 2.70 = US$ 1.00
(May 20, 1998)
FISCAL YEAR
January 1 - December 31
ACRONYMS AND ABBREVIATIONS
AEF
APDF
ATM
COOPS
EC
ECCB
ECEF
ECHMB
FDI
FTC
GDP
IFC
INDECOPI
LUCELEC
OECS
SWOT
Africa Enterprise Fund
Africa Project Development Facility
Automated Teller Machine
Cooperatives Strengthening Project
Eastern Caribbean
Eastern Caribbean Central Bank
Eastern Caribbean Enterprise Fund
Eastern Caribbean Home Mortgage Bank
Foreign Direct Investment
Federal Trade Commission
Gross Domestic Product
International Finance Corporation
National Institute for the Defense of Competition and Intellectual Property Rights
St. Lucia Electric Services Ltd.
Organization of Eastern Caribbean States
Strengths, Weaknesses, Opportunities, Threats
Vice President
Country Director
Sector Director
Task Manager
Shahid Javed Burki
Orsalia Kalantzopoulos
Danny Leipziger
John Pollner
-i -
OECS FINANCIALSECTOR REVIEW
TABLE OF CONTENTS
Executive Summary............
Page iii
Part I
General Economic Background.Page
Part II
Overall Assessment.....................
Fragmentation.Page
Fractionalization.Page
Page 2
2
4
Part III
The Financial System.Page
ECCB .Pag
FinancialIntermediaries.
CommercialBanks...................................
Credit Unions.Page
8
8
Page 10
Page 10
17
Development Banks..
1
Page 18
General Insurance.Page
19
Social SecurityFunds, Private Pension Funds & Life Insurance....Page 21
Part IV
SecuritiesMarkets.Page
Government Securities Market....
Mortgage Market
The Capital Market............
Part V
Market Capacity & Risk Considerationsin Developinga Capital Market. Page 33
Potential Issuers .Page
33
Potential Investors.Page
34
An EnablingEnvironmentfor a Capital Market
Page 35
Part VI
Conclusions and Other Issues.Page
38
ECCB - Institutional Issues .Page
38
Bank Safety and Supervision.Page
Supervisionand Regulation of Non-Banks
25
Page 25
............ Page 27
Page 27
38
Page 39
-
ii -
Monetary Management ...........
.....................
Page 40
Other ECCB Functions ...........
.....................
Page 40
World Bank Support ...........................................
Page 40
Annex 1: Regulatory Elements for the Functioning of a Securities Market ......... ......Page 42
Bibliography...................................................
Page 43
Researchand preparationof this reportwas conductedby a team consistingof John Pollner
(Task Manager,LCSFP),Meir Kohn (PrincipalConsultant),Steve Webb (Sr. Economist,
LCSPR),and IsabelleDaverne(FinancialConsultant). Key discussionsand inputs for this
purpose,wereprovidedby Mr. DwightVenner,Governorof the ECCB,and Messrs.Arthur
Campbelland JamesFlemingof ECCB'sFinancialandEnterpriseDevelopment
Unit.
- iii
-
EXECUTIVE SUMMARY
1.
The EasternCaribbeanhas benefitedfrom monetaryand price stabilityin the quarter
centuryin whichmost islandsobtainedindependencefromBritain,and has avoidedthe financial
crisesthat hobbledeconomieselsewhere. The Eastern CaribbeanCentralBank (ECCB)and the
membercountrieswant to continuethis laudablerecord whileat the sametime modernizingthe
financialsector and makingit a dynamicforce for economicdevelopment.Thisis especially
importantas the end of the centuryfinds stagnationor declinein severaltraditionalsectors.
2.
Despiteits avoidanceof crises,the financialsector has seriousproblems. Most of them
are in three categories- geographicfragmentation,industryfractionalization,and shortageof
institutionsto providelong term andventure capitalto the private sector:
(i) Fragmentationresultsfrom legal and regulatoryobstaclesthat block integrationwithin
the Eastern Caribbeanand de-linkit fromthe internationalfinancialsystem.
(ii)Industryfractionalizationwhichgeneratesdiseconomiesof scalein each country,
results fromboth fragmentationof the sub-regionalmarket,proliferationof 'transaction
intermediaries'that add littleto resourcemobilizationeffortsin the industry,and high
costs of intermediationdue to the scaleof lendingversus otherfinancialinstitutions.
(iii) Changesof technologyand globaltradingpatterns shouldbe openingnew
opportunitiesfor the economiesto shiftaway from decliningsectors, such as sugar and
bananas. But lack of institutionsto mobilizefinancingfor private sectorventures,
combinedwith scarcityof humanresources,and regulatorybarriers,hindersdynamic
adaptationof the economies.
3.
The ECCB has taken the lead in developingwith membergovernments,a programto
create a singlefinancialspacefor the EasternCaribbeanand to upgradethe sector to help the subregionaleconomymeet the challengesof the next century. The ECCBis seekingand shouldbe
givensupportwithinthe regionand externally,to design,refine,and implementthe program. The
on-goingprojectsto improvefiscalmanagement,publicsector efficiency,and the overallclimate
for businessalso deservesupport as importantcomplementsto financialsector efforts.
Financial Sector
4.
Commercialbanks are and will remainthe backboneof the area's financialsystem.The
branchesof the four foreign-ownedbanks, whichaccountfor roughlyhalf of deposits,and some
of the indigenousbanks are sound, someare not. The problemsstem in part from the dependence
of indigenousbanks on the smallundiversifiedeconomiesof individualislandsand occasionally
inappropriatepoliticalinterferencein lendingpolicies.
(i) The ECCB's ongoingprogramof assuringprovisioningfor losses, strengtheningbank
management,privatizationof publiclyownedbanks, and mergingbanks across islands
shouldcontinue.
(ii) To providesafe, competitiveand efficientbankingservices,the systemwillneed to
rationalizebanks on each island,eachone operatingbranchesat least throughoutthe
EasternCaribbeanin order to achieveadequatescaleand diversity.
-iv -
5.
Credit unions, Development Banks, and Insurance Companies are important
complementsto the commercialbanks. Nationalgovernmentshave supervisionresponsibilityfor
them, but generallylackthe capacityto do so adequately.The ECCB is workingwith
governmentsto supervisethese institutionsand direct their rationalization.This program should
continue,and ECCBshouldfacilitatethe standardizationof regulationsand supervisorypractices
as an informationbroker and disseminatorof best practice.
(i) Whilea combinationof mergersand exits in the 1990shas substantiallyrationalized
the life insurancesector, generalinsuranceis plaguedby excessivetaxation, a commission
structure whichprovidesdistortedincentivesagainstcapitalreserves,and the proliferation
of smallinsurers,whichimpairsefficiencyand safety.All aspects of insuranceneed tighter
standardsand supervision,supportedwith publiceducation.
(ii) Regulationsshouldbe changedto allowthese institutionsto operatefreelybetween
islands.
6.
Contractualarrangementsfor long-termsavings- pensions,lifeinsurance,and social
securitywhichis currentlythe most important- need to be strengthenedto assure adequate
retirementpaymentsfor today's pool of workers, and to fund investmentfor sustainablegrowth.
The designof these systemsshouldcautiouslybut steadilyevolveto becomefullyfundedand
possiblycontributiondefined,and to take advantageof recentinnovationsin institutional
technologythat allowgreatertransparencyandresponsivenessto investmentpreferencesof
participants.The objectivesof macroeconomicstability,assuranceof minimumretirement
benefits,higherreturns, greater investmentin the EasternCaribbeaneconomy,and international
diversification,competeand conflictto some extent.Thus a balancedapproachwhich
incorporateseach of these elementswithout favoringsome in the extreme,is crucial.
SecuritiesMarkets
7.
Developingregion-widesecuritiesmarketsis an importantpart of the ECCB's plan for
increasingthe financialsector's contributionto economicgrowth. Many steps are neededto
reachthe goal, and the ECCB plansto proceed in a sequentialmanner.Experiencein the region
and elsewhereshouldbe utilized,ensuringthat the basicinstitutionalinfrastructuresand financial
instrumentswhichdrive and provideliquidityto the capitalmarket, are well establishedearlyon.
8.
Establishingan integratedmarket for governmentsecuritieswould be the first step, as a
pool of assets alreadyexistsandvaluationis relativelytransparent. Establishingthis market could
buildup inter-islandinformationand tradingsystems,whichcouldthen be utilizedfor other
securities.
9.
An OECS/ECCBarea-wideequitiesmarket couldhelp fillthe private sector's need for
longer-termfinancingand venturecapital.It willrequire:
(i) Eliminatingrestrictionson inter-islandinvestmentand labor mobility.
(ii) Establishingrules and reliablemechanismsfor paymentand trading,and for disclosure
of informationon companies.
(iii) Establishinga sub-regionalinstitutionto monitorand enforceproper securitiestrading
with adequatetechnologyto assuretimelyinterventions,if needed.
(iv)Generatinga pool of publiccompaniesto increasesharesin circulation;this willbe
moreeasilyencouragedthrough privatizedpublicenterprises.
10. Commercialbanks would need to help handlepaymentsfor capitalmarkettransactions
and couldexecutetrades for customers. Of course they would participatein the government
securitiesmarketwherethey are now the major stakeholders. Theirparticipationand capital
exposurein the equitiesmarket shouldbe limited,however.
11.
Contractualsavingsinstitutionsshouldparticipatein the securitiesmarkets,but this should
be with clear rules on asset risks, especiallyfor disclosureto participants,on changesin market
valuationin the equitiesmarket.
12. The securitiesmarket shouldultimatelybe openedup to allowfor international
diversificationin local portfoliosand local diversificationin internationalportfolios,as prudential
risk reductionmeasuresand to encourageparticipationin equityinvestments.This mightproceed
in a phasedmannerto assurethat domesticenterprisesand firmsare not squeezedout of financing
sourceswhichthe sub-region'senvisionedcapitalmarketsare meantto support.
OECS FINANCIAL SECTOR REVIEW
PART I
GENERAL ECONOMICBACKGROUND
The Organizationof Eastern Caribbean States (OECS) consists of Anguilla,Antigua &
Barbuda, Dominica, Grenada,Montserrat, St. Kitts & Nevis, St. Lucia, and St. Vincent and the
Grenadines.The combined population is approximately 550,000. In 1995 combined GDP of the
OECS was approximatelyUS$1.9 billion or US$3,400 per capita. Per capita GDP varied
significantlyfrom territory to territory, from a high of US$6,800 for Antigua and Barbuda to a
low of $2,000 in St. Vincent and the Grenadines.
Up to the 1950sthe economies of the territories were overwhelminglyagricultural-mainly
specializingin either bananas or sugar. There has since been a steady shift, accelerating in the
1980s, away from agriculture and towards tourism. In general, the territories in which income has
risen most are those in which this shift has proceeded the furthest. Overall,tourism today
accounts for 10.8% of GDP and agriculture 9.3%. Manufacturingremains relatively small (5.5%)
and consists largely of food processing and enclaveindustries such as garments and small
assemblyplants. Construction is significant(9.8%), much of it serving the needs of tourism.
The economies of the territories are very open: imports are 56% of GDP; exports 16%,
servicesbalance 22%. Foreign direct investmentof 7.4% of GDP largelybalances the current
account deficit. A large part of trade is with other CARICOMcountries. Other important trading
partners are the U.S. and the E.U., with both of which it enjoys trade preferences. These
preferences are being phased out, and this is likely to shrink agriculture even further. The
members of the OECS share a common currency (the EC dollar) issued by a joint central bank,
the Eastern Caribbean Central Bank (ECCB). The EC dollar has, since 1976, been at a fixed
parity against the US dollar. Consequently,the sub-region has enjoyed a stable monetary
environment.l
Two aspects of the OECS economies stand out - their very small size and their
vulnerabilityto shocks. Even taken as a whole, the OECS is a very small economy. Moreover,
internal barriers prevent the territories from constitutinga singlemarket, and some of the
individualterritories are quite tiny. Indivisiblefixed costs are consequently a barrier to all forms of
economic activity: the market is so smallthat import is often unprofitable,let alone local
production. The OECS economies are highlyvulnerableto shocks. They are unusuallyexposed to
natural disasters - particularlyhurricanes, and less frequently to drought and volcanic eruption.
Because of their small size,the impact of a natural disaster can be far more devastatingthan for a
larger economy where the damage is localized. Another source of potential shocks is the heavy
dependence on tourism, an industry that is sensitiveto recessions in the tourists' countries of
origin2 . The smallnessof the economies and their exposure to shocks dictate two predominant
concerns: (i) the exploitation of all possible economies of scale and scope; and (ii) the greatest
possible effort to mitigate risk. These considerations,important in the real economy, should be
uppermost too in consideringthe developmentof the financialsystem.
lIn the following, dollar means EC dollar unless otherwise indicated.
Correlations between U.S. and OECS GDP growth rates over a 15 year period bear this out. While non-tourism factors also
impact on OECS growth, given the substantial tourism sector as a % GDP, downturns correlated with the U.S. and Europe
invariably impact the tourist trade in the OECS, not only in service exports but capital investments as well.
2
-2PART II
OVERALL ASSESSMENT
The financialsector of the OECS/ECCB area is poised for an increased pace of change.
The basic institutionalinfrastructure and scope of financialinstitutions in the area have reached a
critical mass, and now stand ready to cooperate in collectivelyaugmentingthe supply of financial
capital throughout the OECS. This should be through taking advantage of economies of
integration and opportunities for deepening the capital markets to generate long-term financing
for developmentopportunities in the private sector. The main institutional playersin the current
structure are the banks, the ECCB, the government securities market, pension funds, insurance
companies, credit unions, finance companies, and the budding private enterprise sector.
The capital market instruments and institutions being utilized and/or considered to achieve
these objectives,include the government bond market, the Eastern CaribbeanHome Mortgage
Bank, a Call Exchange for debt and equity trading, an Enterprise Fund, and a Unit Trust (Mutual
Fund) to provide increased access by investors to a future capital market. All of these institutions
and mechanismsare expected to contributeto the developmentof a more robust market in the
OECS/ECCB area. The importance of sequencingthe implementationof these initiatives so as to
build up the supporting regulatory frameworks and facilitatingmarket mechanisms,however, will
be key factors to ensure a smooth and successfultransition towards a flexiblefinancialsector
which can meet the developmentaland financingneeds of the sub-region. In this respect, this
report attempts to identifythe constraints and existingor recommendedfacilitatingfactors which
need to be addressed and acted on to achieve these objectivesin a timelymanner. This should
pave the way for an enabling financial,legal, and regulatory environmentwhich will provide the
impetus to the proposed institutions and structures. This should generate the envisionedresource
flows within a dynamic and modernizedfinancialsector.
The financialsystem of the ECCB area, however, currently suffers from two major
constraints -- (i) inter-territory fragmentation and (ii) intra-territoryfractionalization.
Fragmentation is the result of legal and regulatory obstacles as well as infrastructure and logistical
factors that block integration within the area and separate it from the internationalfinancial
system. Fractionalization,partiallyrelated to fragmentation,is the result of proliferationof
numerous operations and intermediarieswithin each island, particularlyin the general insurance
and credit union sector but also in banking, thus leading to high aggregate fixed costs, increased
final costs to consumers, and less efficientgeneration of surplus capital in the financialsector.
FRAGMENTATION
Inter-island fragmentation of the financialsystem in the ECCB area is harmful in three
ways. First, it is economicallyinefficient.Differencesin interest rates and in liquidityacross
territories and across institutions indicate that funds are not going to their most productive uses.
As a result, both the level and the rate of growth of area income are lower than they might be.
Second, fragmentation creates domestic financialinstitutions - banks, credit unions, insurance
companies-that are localized and not well diversified.The result is also high operating costs and
reduced safety.
-3 INTEREST RATESACROSS THE OECS/ECCBAREA
Prime Lending Other Lending 6 Month Time Savings
Rate
Rates
Deposits
Deposits
Anguilla
11.00-12.00
11.00-19.50
1.50-5.50
4.00-5.00
Antigua & Barbuda
10.00-11.50
10.00-24.00
2.50-6.50
4.00-8.00
Dominica
9.00-10.50
9.00-19.05
1.50-4.00
4.00-5.50
Grenada
9.50-10.50
9.50-16.00
1.50-4.00
4.00-5.00
10.00-10.50
10.00-27.60
1.50-4.00
4.00-4.00
St.Kitts & Nevis
9.50-12.00
9.50-21.60
1.50-6.00
4.00-5.00
St. Lucia
9.50-10.00
9.50-23.00
2.00-7.00
4.00-6.00
St. Vincent & Gren.
9.50-11.00
9.50-16.50
1.50-5.00
4.00-5.50
Montserrat
The third way in which fragmentation is harmfulis that it prevents the financialsystem
from playing its essential role in spreadingrisk. A recent study investigatedthe mechanismsthat
enabled residents of individualU.S. states to maintaintheir consumptionin the face of shocks to
their state economies.3 It found that the most important mechanism(smoothing39% of shocks to
state income) was the cross-ownershipof productive assets. If households derive investment
income mainlyfrom productive assets in other states, a shock to one state's income has little
effect on its own residents' investmentincome; the effect is spread out over other states. The
second most important mechanism(smoothing23% of shocks to state income) was borrowing
from residents of other states and the sale to them of financialassets. The federal government,
through its system of taxes and transfers, smoothed only 13% of shocks to state income.
The role of the financialsystem in spreading risk is especiallyimportant for the economies
of the OECS, subject as they are to an unusual degree of risk. Fragmentationreduces enormously
the abilityof the financialsystem to fulfillthis role: it places obstacles in the way of crossownership of productive assets; it hampers borrowing from foreigners;and it makes difficultthe
holding of foreign assets that can be sold to support consumptionin the event of a shock to
income. It should be noted, however, that extensive foreign direct investmenthas led to
substantialforeign ownershipof productive assets in the OECS.
The causes of financialfragmentationwithin the ECCB area include the following:
(a) Risk aversionand lack of confidenceby financialinstitutions to expand their lending
operations outside the home territory. This is in part due to the traditional business
culture, but also due to territorial differencesin businesslicensing, disclosure,and tax
practices.
(b) Legal restrictions such as the AlienLand Holding Acts which restrict foreign
(includingintra-OECS) ownership of domestic assets such as real estate and majority
3
Asdrubali, Pierfederico, Bent E. Sorensen and Oved Yosha, 'Channels of interstate risk sharing: the United States 19631990," 0QuarterlyJournal of Economics I I 1, November 1996, 1081-1110.
-4 equity ownership positions in local enterprises. In the case of company equity shares
transacted in the existing private market, each territory has differingrules allowingthe
degree of foreign and intra-OECS ownership.
(c) Differentialtax policies:most territories have withholdingtaxes on the payment of
profits, interest, etc. for non-residentsand foreigners,in contrast to residents. Interest on
government securities and on domestic bank deposits in the majority of cases is tax-free to
residents only. ECCB however, is currently engaged in on-going initiativesto promote
harmonizationand consistencyin these areas and to encourage cross-border integration
and businessactivity.
All of these obstacles also serve to separate the financialsystems of the territories from the
internationalfinancialsystem. Of course, it is not only in terms of their financialsystems that the
area's economies are fragmented. There is very little cross-border economic activity of any kind.
Few business operate in more than one territory. Obstaclescited by businessmeninclude complex
legal and regulatory environmentsthat differ from territory to territory, uncertainty about future
treatment of outside investors, and generallya tradition of conducting business only within the
home territory.
FRACTIONALIZATION
Fractionalizationresults in diseconomiesof scale due to the number of comparatively
small financialinstitutions existent within each country/territory. In the banking sector this is the
result of two factors:
(i) due to the traditional practice for domesticallyowned businessesto conduct banking
within singleterritorial borders, cross-border diversificationand operational efficiencieshave not
been fullyachieved, as discussedabove. This has resulted in less diversifiedportfolio 'hedging'
against credit risks, proportionatelyhigher fixed costs per institution,and thus higher overall
intermediationcosts. In addition, such diseconomiesof size do not provide sufficientflexibility
(both institutional and financial)to domestic banks, for developing much needed, new financial
products to provide additional investmentliquidityfor private enterprise. Such products include
the offered fixed income instruments (e.g.: commercialpaper, banker's acceptances) to investors
as well as longer-termlending products to borrowers. The institutional capabilitiesfor
accelerating the circulation of funds in the financialsector, and facilitatingsecondarymarkets
through potentially dealing in government securities and equities, is also constrained by the
relative size, technical infrastructure, and capital requirementsof the domestic banks. This is not
to say that bigger is alwaysbetter, but rather to recognizethat there are minimuminstitutional and
capital requirementsneeded to prepare the banking sector for a larger role in augmentingthe pool
of investmentfunds. In this regard, the additionalcomplexityof such operations would imply
some degree of capital expansion,and possibly,industry consolidation.
(ii) due to the earlier role of foreign branch banks which lent primarilyto foreign business
enterprises, the indigenousbankingindustry grew to meet the demandfor domestic needs
includinghousing finance, domestic business, and public enterprise operations. This separation of
roles, while meeting emergentneeds, also resulted in an increase in the number of domestic
institutions, which, due to their independentexpansionwithin each territory, necessarily implied
operations of relatively small asset portfolios and thus higher operating expense / asset ratios. This
-5 -
effect increasesthe spread between rates savers receive and rates borrowers pay and reduces the
range and volume of financialproducts availableto them. Further consolidationat the national
(and sub-regional)level as well as further OECS-wide integration of the industry would mitigate
these diseconomiesof scale and reduce the current fractionalizationin the industry. This could be
accomplishedmore effectivelythrough further privatizationof government owned banks in order
to promhotea larger equity market while allowingthe private sector to consolidateto achievea
more optimalefficiencyequilibrium.
The public sector role should focus on facilitatingan integrated area-wide market for
government securities, which would be highlybeneficialfor the OECS financial system. With the
fixed costs of market infrastructureborne by the government securities market, the marginalcosts
of adding trading in other securities (such as private bonds and equities) would be much lower.
Liquid T-billswould provide ideal collateral for short-term lending. Government debentures
would make an ideal safe asset for contractual savings institutions (lifes and pension funds).4 The
ECCB has already started initiativesaiming to equalizethe tax treatment of government securities
in the OECS, and this shouldbe given priority due to the benchmarkingfunction and maturity
range which government securities offer in setting the base for the capital market.
The phenomenon of fractionalizationis even more prevalent in the general insurance
industry and in the credit union sector. A proliferationof 'market' players for property and
casualty insurance,including brokers and agents, as well as a number of primary insurance
companies, exceed the per capita needs of the OECS. Primarycompanies themselves are subject
to strong commissionincentivesby ceding their domestic portfolio coverage to international
reinsurers. The broker and agent businesseswhich primarilyserve the primary companies to
attract customers, are net commissiondriven concerns, and at current supplylevels, impede
effective capital market developmentand risk spreadingfunctions of well-capitalizedinsurance
intermediaries.Thus, the diseconomiesof intermediationcaused by this fractionalizedindustry
prevents this sector from deepeningthe capital market. The widespread competition for direct
fees discouragesprimary domestic insurers from accumulatingreserves which could be deployed
into the financial system. This along with tax disincentivesin this sector, results in a high dividend
paying industry, a high dependence on foreign reinsurance, and continued fractionalization.With
respect to the credit union sector, this serves smaller community-basedconstituencies,but there is
some room for economies of scale both within each territory and across the sub-region, by
consolidatinginstitutions serving similarcommunitygroupings with common interests and/or
attributes, such as government employees.
Recommendations (Also see Part III 'Financial Integration')
a. Tax Reform: To further financialsector integration and outside investment,there
should be no tax preferences or differentialtreatment for specific financialassets -- in particular,
tax differences in this regard within the OECS territories, mitigate against sub-regionalfinancial
integration. Interest on government securities, on local bank deposits, and on the bonds of the
ECHMB should be taxed consistentlyand in line with other investmentincome. Taxes on
4However, a market for government securities would not, as has sometimes been suggested, provide "benchmark" rates for
private borrowing. Given the monetary regime, the debt of individual governments is analogous not to federal debt in the
United States, but to state or municipal debt: since OECS governments cannot monetize their debt it is not risk-free
(conceivably,private borrowers might be able to borrow at lower rates than some governments). Again given the monetary
regime fixed to the US dollar, benchmark rates already exist - those of the US dollar market.
-6foreignersor foreign holdings of domestic investments should be minimizedor avoided when
these have the effect of protecting domestic concerns at the expense of a level-playingcompetitive
environmentwhich would otherwise encourage inflows of external capital. Taxes on the transfer
of securities (stamp duties) should be phased out since their existenceis an obstacle to creating
liquid secondarymarkets in tradable financialinstruments.
b. Legal and Regulatory Restrictions: AlienLand Holding restrictions should be revised
and/or repealed, particularlywhen these affect intra-OECStransactions, but also to allowvalueadded foreign investmentconcerns to contribute to the domestic economies. Withholdingtaxes on
foreign investmentincome should be phased out, when similartreatment is not applied to
equivalent resident income, and when such foreign investmentincome is already taxed in the home
country5 . Delays for foreign as well as domestic lenders in enforcing debt contracts in domestic
courts, shouldbe minimized.Short of undertaking a major judicial sector reform, this could be
achievedvia the establishmentof a trade & commerce agency which would have administrative
powers to rule on commercialdisputes on a fast track basis. Such an agency (modeled along the
lines of the U.S. FTC or Peru's INDECOPI6)would be staffed and guided by professional
specialistsfrom the private sector contributingtechnical/egal advice on a part-time as-needed
basis. While the judicial system could stillbe accessed subsequentlyby the litigants,the
administrativetrade/commerce agency (as in other countries) would likely discourage such
appeals given its professionalcompetence and technicalbacking on administrativerulings. The
agency would strive to be self-fundedby chargingfees for its serviceswhile minimizingthe need
for formal, more costly and time consuminglegal sector interventions.
c. Exchange Controls: Licensingand administrativeprocedures required for the
acquisitionof foreign financialassets shouldbe simplifiedto encourage investmentinflows and
diversifythe savingsbase to assure safety and long-run stability.As discussed later in the report,
regulations can be put in place to avoid merely speculativecapital flows from destabilizingthe
financialsystem. Domestic savers and, more important, domestic financialinstitutions should not
be discouragedto acquire foreign financialassets -- authorization procedures for this should be
limitedto complyingwith proper monitoring of foreign exchange transactions, and this could be
optimizedvia ex-post rather than ex-ante reporting requirements.Small savers are unlikelyto
purchase foreign financialassets directlythemselves. The current procedures make it difficultfor
them to do so indirectlythrough financialinstitutions.It would be desirable, for example,for
banks to offer domestic savers mutual funds partiallyinvested in foreign securities.
There may be some concern about the consequencesof exchange liberalizationon the
balance of payments. The purchase of foreign assets is balancedby saving (with a reduction in
imports), by foreign direct investment(which is already substantial) and by foreign portfolio
investment(which may increase with developmentof the capital market). In the event of a natural
catastrophe or severe economic downturn, the sale of foreign assets would balance an increase in
imports, serving to stabilizethe balance of payments. Thus, whilethis entails transferring some
control of foreign exchange and foreign savings diversificationto the private sector, the benefits
of such diversificationand security in access to funds outweighs the risks of restricting investment
to home markets. While intra-OECS liberalizationwill to some extent mitigate this, it only reflects
While this practice varies by country, those countries with successfil FDI experience have avoided such taxes.
In the U.S. this is the Federal Trade Commission. In Peru, INDECOPI is the Institute for the Defense of Competition and
Intellectual Property.
5
6
-7 a first necessary step in the process of integrating the sub-regionalfinancialsystem and
subsequentlyusing it to tap the internationalcapital markets. Under the practice of virtuallyfull
backing of the currency, capital flightwould be counteracted by upward adjustments in domestic
interest rates due to reductions in the supply of credit. This adjustment,however, would serve to
make domestic financialinvestments more competitivein order for the banking system to attract
additional funds to meet borrowing demand. In any event, a phased-in regime for such
liberalizationmight be more adequate in the OECS context. Foreign portfolio investmentlimits as
a percentage of total assets held by individualsor institutional investors could meet diversification
objectivesand mitigate capital flight.
-8PART HI
THE FINANCIAL SYSTEM
Eastern Caribbean Central Bank (ECCB)
The ECCB acts as a currency board, standingready to exchange US dollarsfor EC dollars
at a rate of EC$2.70 = US$1.00. The ECCB is required to back at least 60% of its monetary
liabilitieswith foreign currencyassets. Actual backing is 98%. Up to $100,000 (per transaction)
may be converted into foreign currency without formality.Larger amounts require authorization.
ECCB lendingto member governmentsis strictly limited by statute.7 It provides a smallamount
of export credit guarantees.
The ECCB operates an interbank market for reserve deposits, and is ready to lend to
banks for reserve management at administereddeposit and lendingrates, for periods up to 30
days. Borrowing banks must collateralizewith fixeddeposits, T-bills, or other acceptable paper.
Banks do not take advantage of this facility:presumablythe alternatives are less expensive or
more informal. The ECCB also manages what is in essence a call repo market (the secondary
treasury bill market/discountwindow). It makes a portion of its portfolio of domestic T-bills
available for discount to commercialbanks and stands ready to rediscount at the banks'
discretion.Banks rediscount when liquidityis tight. Discount and rediscount rates are
administered.In addition, as a separate facility,banks with excess liquiditycan also make deposits
with the ECCB in a 24 hr./7-day call account, at a competitiveinterest rate. The ECCB also offers
banks fixed deposit accounts at prevailingmarket rates for periods of 1,2,3, and 6 months.
The ECCB is the sole supervisor and regulator of commercialbanks in the member
territories (all of which recently passed a uniformbanking act). Banks must submit periodic
financialreports and are subjectto regular on-site inspection.All other financialinstitutions -offshore banks, insurance companies, and credit unions -- are regulated and supervised by the
individualterritories, sometimeswith advice and assistance from the ECCB. Banking supervision
procedures appear to be well organized, but there seems to be a need to develop more 'crisis'
contingencyplanning and readinessfor potential systemicproblems,even though at present such
threats are not on the horizon due to the stable macroeconomicsituation and the monetary regime
includes a number of statutory safeguards (see Box 1) to maintain discipline.
Somewhatworrisome, however, is the sector's reported non-performingloan rate for the
domestic banks which on average represent about 10% of the portfolio. While such a proportion
is not "critical" relative to the entire portfolio, it is significantlyhigherthan internationalpractice.
In addition, loan loss provisionsfor banks with higher non-performingloans are not fully
adequate, as they have been adapting to recently implementedstricter provisioningrequirements
for non-accruingassets. Therefore, while immediaterisks are not major, careful monitoring of
bank portfolios and their compliancewith loss provisioningshould be an on-going priority to
assure the preservation of usable capital. Such capital will be essentialto support the proposed
capital market's institutionalinfrastructure. As will be explainedlater, the banking sector's role in
providing liquidityto an emergingcapital market willbe significant.
7
The ECCB has allocated credit lines to member governments based on its 60% backing requirement. It is because most
governments have not drawn in these credit lines that the backing ratio is so high. See also Box 1.
- 9Box 1: The OECS/ECCB Monetary Regime and its Safeguards
The ECCB area is a monetary union of eight island micro-economies,which by definitionis
characterizedby the issuance of a single common currency, the flow of which is unrestricted among its
members; a commonpool of foreign exchange reserves; and the existence of a central monetary authority,
which decides on monetary policy. Although a monetary union, the responsibilitiesand powers of the
ECCB are in many ways similar to those of other central bank. The ECCB has the statutory responsibility
to regulate the availability of money and credit; to promote and maintain monetary stability; to promote
credit and exchange conditionsand a sound financial structure conduciveto balanced growth and
development.
The main central banking functionsprescribed in the ECCB Charter relate to the foreignexchange
cover, the limits on the amount of credit which can be extendedto governmentsby the Bank, and the
regulation and supervisionof banking business. In relation to the foreign exchange cover, the ECCB is
required at all times to maintain external reserves in an amount not less than sixty per cent of the value of
currency in circulationand other demandliabilities.With respect to lendingto governments,the Charter
stipulates that the Bank may extend a limited amount of credit to participating governmentsby way of
temporary advances to meet seasonal needs, and by way of holdings of Treasury Bills and government
bonds. For the purpose of regulation and the conduct of monetary policy, the ECCB has among other
things, the authority:
(i) to impose reserve requirements;
(ii) to purchase from, sell to, discount and rediscountfor financial institutions, bills of exchange
and promissory notes maturing within 91 days;
(iii) to grant secured advances or loans to financial institutions for periods not exceeding91 days.
The ECCB is thereforenot a currency board, although in keeping with the limitationsof its charter,
its operations have broadly resembledthose of a currency board. The ECCB currently maintains a foreign
exchange cover of 98 per cent, and generally over the years, the cover has been maintained at a level in
excess of 80 per cent. The ECCB extends limited amounts of credit to participating governments, and on
occasions has also made secured advances to commercialbanks, although in recent times this latter activity
has been rare. The ECCB also operates a repurchase arrangement,whereby it sells Treasury Bills acquired
in the primary market for its own portfolio to commercialbanks on a repurchase basis, to enablethe banks
to better employtheir excess reserves. As it pursues its efforts to developthe government securities market
on a region-widebasis, the ECCB intendsto maintain the strictures that have governed its operations. Any
support that it may provide to the market would thereforebe consistent with the current limitations on the
holdingsof governmentsecurities as prescribed by the charter.
The ECCB is committedto the maintenanceof the fixed exchange rate for the EC dollar. The rate
has been maintainedunchanged since the establishmentof the link in July 1976 with the US dollar. The
fixed exchange rate policy has servedthe currency area well, and over the years, the countries have been
able to achieve relative price and balance of payments stability, and relatively good rates of economic
growth. This policy has generated considerableconfidencein the EC dollar both within and outside the
currency area. It has also enhanced the environmentfor decision-makingin relation to production and
pricing, and for savings and investment.
Stability in the value of the EC dollar is the primary objective of ECCB. It is recognizedthat this is
dependenton continued strong backing for the currency. All the operations and activitiesof the Bank will
continueto be made consistentwith this overridingobjectiveof monetary stability with a fixed exchange
rate.
- 10-
FINANCIAL INTERMEDIARIES
Financialintermediariesas a whole hold a total of $8 billion in assets. Commercialbanks,
with 72% of this total ($5.8 bn.), dominate the financialsystem. In comparison, social security
funds hold 16%; credit unions, 5%; insurance companies,4%; and developmentbanks 3%. The
ratio of M2 to GDP, a standard measure of the "depth" of a financialsystem, is 90%, which is
quite high by internationalstandards. Non-resident deposits amount to 12% of total deposits.
MONETARYSTATISTICS
(EC$ Mn.)
M2
Currency Demand
deposits
Savings
Time
Forex
M2 as %
deposits
deposits
deposits
of GDP
Anguilla
318
8
9
36
50
216
172%
Antigua & Barbuda
1,118
69
192
388
411
58
95%
Dominica
Grenada
Montserrat
491
709
109
27
53
12
77
96
18
207
356
55
175
174
17
5
29
7
86%
100%
74%
St.Kitts & Nevis
711
29
71
225
307
78
122%
St.
Lucia
1,132
63
167
432
452
17
83%
St. Vincent & Gren. | 600
Total ECCB Area
5,188
31
292
115
7745
207
1,906
238
1,824
9
420
87%
96%
Dataas of June 30, 1997
Commercial Banks
The five "branch" banks were operating as branches of foreign banks at the time the
territories became independentand were allowedto continue as such. Most of these branch banks
operate in more than one territory. There are eighteendomestic/indigenousbanks -- governmentowned, private, and subsidiariesof foreignbanks. Foreign banks that have entered since
independencehave been required to establish capitalizedlocal subsidiariesand are included in the
category "indigenous." With the exception of one cross-border branching operation, the
indigenous/domesticbanks have restricted themselves to their home territories and most are single
unit banks.
While the domestic banks have expanded aggressivelyin recent years and now account for
over 50% of bank assets, they are individuallyquite small,thus fractionalizedas an industry. The
largest have assets of US $150 millionto $200 millionequivalent; the smallest, under US$20
millionequivalent.The small size of these banks places them at a disadvantagerelative to the
foreign branch banks. Because of fixed cost requirementsat start-up, a branch operation is less
costly to establishand to operate than an independentbank of comparable size. Moreover,
branches of large banks enjoy financialeconomies of scale (better diversificationand better
liquidity)as well as reputational advantages. The branch banks are generallyperceived as being
safer, and this may allow them to attract deposits at lower rates.
Within the ECCB area the bankingmarket is highlyfragmented.Interest rates vary widely
and differ from US dollar rates. Liquidityvaries both across territories and across institutions, and
funds do not flow freely from one territory or institutionto another. (The reasons for this
fragmentation are discussed further below as well as in the associated payment systemsreport).
The geographic fragmentation of the bankingmarket exacerbatesthe scale problem and
fractionalizationof the domestic banks, sincetheir potential growth is limited to an individual
territory.
There is some interbank lending, although its scope is limited. The ECCB brokers a
market for interbank loans. The rate is administeredand the loans, which must be collateralized,
are guaranteed by the ECCB. There is also a private market for unsecured interbank loans, the
terms of which are negotiated bilaterally.The foreign branch banks manage their liquidityon a
subregionalbasis, with one branch covering the reserve requirementsof another. The branch
banks tend to favor the ECCB-brokered interbank market; while the domestic banks prefer the
private market. Banks also manage liquidityby actively solicitingtime deposits in lieu of
borrowings, from large commercialand institutional customers.
The domestic banks are well aware of these problems of fractionalization,scale, and
fragmentation. The 11 larger domestic banks are currently discussinga joint initiativethat might
encompass (i) a jointly-owned lending subsidiarythat could diversifyacross territories and fund
loans that were too large for individualbanks; (ii) an expansionof the existingjoint credit card
facilityto link ATMs and to support debit cards; (iii) an investmentbanking subsidiary;and (iv)
the joint acquisitionof problem institutions both inside and outside the OECS. Such initiatives
support the objectivesof the ECCB's capital market developmentstrategy, and reflect positive
steps in mnitigating
the constraints of market fractionalizationand fragmentation.
The safety of the branch banks is not a major issue: each is a very smallbranch of a very
large, well-capitalizedmultinationalinstitution.With respect to the domestic banks, detailed
informationon problems (or their absence)were not disclosed.However, the small size of even
the larger domestic banks and their lack of diversificationleave them quite vulnerableand their
safety as mentioned earlier,may be a cause for concern. Some consolidationof the industry would
generate economies of safety, scope, and operating cost, provided that the balance sheets of banks
wishing to merge were sufficientlyhealthy at the outset.
Local banking markets are characterizedby vigorous competition. Banks compete for time
deposits with one another, with non-bank financialinstitutions, and even with non-financial
companies. Banks also compete aggressivelywith each other and with non-bank lenders in
consumer lending-mortgages and installmentloans (especiallyautomotive), although there is
considerablyless competition in business lending.Despite this competition, spreads between
average loan rates and average deposit rates remain high by internationalstandards. Possible
explanationsinclude the impact of reserve requirementson financialcosts of relativelysmall
banks; the substantial holdings of only medium-yieldingassets such as government securities;and
lack of profitableloan opportunities that often keep liquidityhigh (with correspondinglylower
asset yieldsinsufficientto fully cover deposit rates and pro-rated operating costs).
Complaintshave been heard that lending rates, especiallyon businessloans, seemed
relativelyinsensitiveto excess liquidity(that they were "inflexibledownwards"). This
-
12 -
phenomenonis not specialto the OECS: it is well known in other countries. It is a result of
banks' market power with respect to their businessborrowers (for informationalreasons, the
latter cannot easily switch lenders), as well as the perception by banks that significantlylarge
cushions of liquiditymust be maintainedto safeguardagainst potential market and credit risks.
Thus, the holding of substantiallower yielding liquid assets must be balanced by higher yielding
loans to ensure coverage of banks' borrowing and operating costs. The phenomenon may be
somewhat augmentedin the OECS by the rigidity in some interest rates (e.g.: ECCB lending rates
and yields on government securities), which are administeredrather than market-determined.
Recommendations
a. FinancialIntegration: Commercialbanks are, and will remain, the backbone of the
financialsystem. Consequently,the efficiencyand safetyof the banking system is of paramount
concern. Beyond reducing regulatory and other constraints that create financialfragmentation, an
urgent priority is to reduce the fractionalizationof the industry via the integration and/or
consolidationof banks. ECCB should encourage any initiativeson the part of the domestic banks
in this direction.Moreover, where foreign banks provide promise of sub-regionalintegration, the
area governments should encourage acquisitionof domestic banks by sound institutions, whether
these be sub-regional,regional, or internationallybased. The domestic banks are unhappy about
recent acquisitions in the area by a Trinidad-basedbank. However, acquisitionsby foreign
institutions are not only desirable due to economies of scale and diversification,but also because
they applypressure on the domestic banks to integrate sub-regionally,reduce intra-island
fractionalization,and become more competitive.
To facilitate intra-OECSbank cooperation, additional developmentof a repo market in
government securitieswould greatly facilitatethe expansionof interbank lending and thus the
integration of the banking system. Current options for interbank lending seem limited:the ECCBbrokered market maybe consideredtoo formal for banks wishingto avoid unnecessaryvisibility;
the bilateral 'private' banking market being unsecured, is somewhatrisky. Reliable sources of
short-term funds (with low risk to the suppliers)would not only support sub-regionalbanking
integration, but also increase the stock of liquidityneeded to support a flexiblecapital market
infrastructure.This is particularly relevantfor the envisionedcross-border purchases of company
securities, where banks serving as payors on behalf of investors (via their deposit accounts) may
need to request banks in the territory of the share/securityissues, to advance them funds for
effectingpurchases in 'real-time', while interbank settlement arrangementsare being executed.
In this respect, the recommendationsraised in the payment systems study, would be of a
priority to begin putting in place a state-of-the-art financialinfrastructure. This is particularly
relevant in the OECS/ECCB area context giventhe geographicalland separation among the
territories. In addition, in terms of sequencing and establishingthe necessarybusiness conditions,
it is highlyrecommendedas a first step, that the sub-region's governments in conjunctionwith the
ECCB, assure an enabling environmentfor a single financialspace. This would be achievedby
legislatinguniform/one-timeprocedures for the simultaneousregistrationand licensingof banks
across the territories without needing individualcountry registration/licensingprocedures,
especiallyfor banks wishing to expand across territories.
b. ReserveRequirements: Current reserve requirementsare based on the stock of both
savingsand time deposits, and also are used as bank clearing accounts. While in percentage terms
- 13 -
they are not excessive,given the comparativelysmall size of some bank's assets, this could
marginallyimpact on the spread between deposit and lending rates. To provide more flexibility,
the averaging period on which the level of reserves are calculated,might be extended (e.g.: to 30
days) thus allowingbanks additionaloptions in their managementof funds. As also recommended
in the payments systems study, more efficienttechnology will serve to minimizesettlement delays
and thus transactions and lending costs. Banks may also be at a disadvantagein the competition
for time deposits from non-banks not subjectto reserve requirements.Rather than reduce reserve
requirementsto resolve this, it is recommendedthat close monitoring of non-bank deposit-taking
operations be continued and that these be classifiedas banks. Where non-bank deposit taking is in
the form of commercialpaper, these instrumentswould be covered under proposed capital
markets and securities regulations which will be required under the initiativesbeing proposed.
c. Capital Requirements:The current capital requirement is 8% of Tier 1 and Tier 2
capital combined.Currently most banks more than fulfillthis requirementby holding 8% of Tier 1
capital, thus exceedingBasle standards. The Basle requirementswere designed with much larger
and better diversifiedbanks in mind: the smaller the bank, the higher the capital ratio required to
provide the same degree of safety. The fact that many of the indigenousbanks voluntarilyexceed
the requirement suggests that they understand this (as do their depositors). ECCB also requires
banks to hold capital equivalentto 5% of their deposits. These requirementsdo not apply to
foreign branches of banks which are required to submitto ECCB a 'comfort letter' from the
parent banks, guaranteeingthe requisite capital backing for their OECS operations. As mentioned
earlier, a priority issue does not pertain to useable capital but rather to banks' loan loss reserves.
As a safety and prudential measure (and to mitigate against growth in the non-performing
portfolio of the banking sector), ECCB should continue reinforcingthis area of monitoring and
work with the area governmentsto assure full compliancewith minimumprovisions.This is
particularly important to assure the banking sector's solvency once the capital market (and thus
the opportunities for enterprise financing)begins expanding.
d. Equity Holdings: While current law restricts banks to hold no more than 10% of an
individualcompany's equity, it does not restrict the total amount of equity holdings (i.e.,
diversifiedacross companies)that a bank may hold as a percentage of its capital. Currently,
however, OECS banks restrict their equity holdings, but with the developmentof the sub-region's
capital markets, banks are likelyto participate as institutional investors and thus wish to increase
such holdingsto achieve capital growth. Holding of equity stakes by banks would support future
capital market depth and allow banks to perform a role in corporate governance in the assessment
and disclosure of traded securities. However, due to the riskinessto the banking sector of
allowing it unlimitedequity holdings, limitationson their asset portfolios (e.g. 15%-30% of total
earning assets), might be considered, as a prudential safeguard under an integrated banking and
securitiesframework.
Since commercialbanks have a well developed financialinfrastructureto broker and
purchase or sell securitiesto individualinvestors not able to access a formal exchange, they might
also serve to facilitate the trading function within an over-the-counter market. Given the proposed
restrictions on their own equity holdings,they would not function as typical 'investment banks'.
Rather they would reflect a hybrid set-up combiningthe U.S.-style separation between
commercialand investmentbanks, and the German/Frenchstyleuniversal banks. They would be
allowed a minimalequity stake in the market as well as brokering functions,but would primarily
function as commercial(lending) banks. The OECS/ECCB proposal also envisionsutilizing
- 14 -
developmentbanks as a nexus in each island, for investors to obtain informationon securities and
to trade them at those locations. While a role for developmentbanks as information centers might
be useful, there are some limitationsin terms of operationalizingthis approach, as discussed
further below. These limitationspertain to the nature of developmentbanks as non-deposit-taking
institutions, giventhat deposit-takingwould be a necessaryfunction for capital market broker
agents to perform, in order to expedite payment and settlement procedures in an active securities
market.
e. Government-OwnedFinancialInstitutions: In the ECCB area, governments own or
have controllinginterests in four commercialbanks. In order to facilitatethe availabilityof an
attractive equity market, governments shouldprivatize through public sale, their controlling
interests in banks, insurance companies, and other financialinstitutions that they now own. Some
developmentbanks or the high performing portions of their portfolios should also be considered
for privatizationand placing on a commercialbasis (including perhaps mergingwith some of the
national commercialbanks and sold as one package). Governmentsmight also wish to consider
the privatization of the social security system (as discussed below). While conversion to a
contribution defined system might also be consideredunder public sector management, the risks
of this are potentiallygreater if such funds end up restricting a large portion of their investments
to government fixed income securities.While privatizationof national commercialbanks is being
considered, management of public enterprise bank accounts held by such banks, should also be
subject to competitivebiddingby the rest of the private commercialbanking sector.
f Offshore Banking and Other Issues: The OECS/ECCB area governmentsare keen on
developing and expanding the offshore banking business.There are three major configurations
availablein developing this sector. These include the institutional and regulatory set-up of
offshore accounts under of the following alternativesand/or their combinations:(i)
Accounting/legalbrass-plate banks / trust accounts, (ii) Deposit centers in OECS, holding foreign
currencies only, and (iii) Domestic or branch banks managingoffshore and domestic accounts. In
the latter case, legislative/regulatoryprovisions and their strict enforcementare needed to fully
segregate domestic and offshore businessas separate industries.This is also key in order to avoid
' system leakages' which would open the door for moneylaundering activities. In addition,
budding offshore bankingmarkets in the OECS should be segregated from domestic banking
activity to avoid 'cross-sector' flows which could underminethe stabilityand integrity of the
banking system.
The offshore bankingindustry typicallydoes not provide servicesto residents in the
territories in which such operations are established.Nor does this industry use or invest funds
from the local market. As mentioned above, in the simplestform, the offshore industry is
represented by 'paper' operations which generallyconsist of a local legal/accountingoffice which
books the offshore accounts. These officesgenerallytake the legal form of trust or limited liability
companies and do not conduct any business on the domestic market. The advantages to the clients
of these services,are tax benefits, and confidentiality.Invested instruments are generally from the
external foreign market, as are the trading agents which execute these. More complex
arrangementsinvolvethe above set-up but also include limited local operations. Examples of
these are captive insurance companieswhich are proprietary in that they only service clients which
have controllinginterests. The most challengingto regulate, however, are those operations which
have local banking, insurance, and other services,as well as offshore accounts.
-
15 -
Offshorefinancialcenters can offer one or more combinationsof the above. In order to
create an attractive environmentfor these, governmentsusually set out the followingregulatory
parameters: (i) legislation authorizingspecificvehicles such as trust companies or certain financial
institutions to conduct offshore business; (ii) low or no taxes on income or profits from such
operations; (iii) tax treaties allowingfurther advantagesunder the counterpart country's tax
regime (e.g.: exemptionfrom withholdingtax); (iv) low stamp duties, value added, or inheritance
taxes; (v) confidentialityvia restrictions on public inspection of filing,and limited disclosure
requirements;(vi) exemptions for the offshore sector from exchange controls or limits;and (vii)
simplifiedlicensingand other administrativeformalities.Prudential regulatory requirements and
supervisionusuallyapply to those operations also offeringtraditional servicesto parties in the
local market, and is concerned mainlywith capital adequacy requirements.
The developmentimpact of offshore operations can vary substantially.The 'paper'
booking companies add little value in terms of employment,which is usuallylimited to clerical
staff and ancillaryservices such as computer and telecommunicationssuppliers. Foreign exchange
earningsto host governments depend mainly on volume since, due to high competition, annual
'maintenance' fees charged by host governmentstend to be low, as are taxes. The limited
incrementalemploymentyields little additionaltax revenue from local income taxes (where
applicable).On the other hand, the tasks of the government are relatively straightforwardand
essentiallyare limited to adopting the proper legislation and assuring and effectiveregistry for
offshore operations. Additional developmentimpact is achievedwhen such operations also have
larger local operations, albeitrestricted to offshore businesstransactions. Local employmentis
increased and higher levels of skills transfers are achieved.Related services such as auditing,
accounting, as well as housing, are also generated. Income taxes may apply both to local
employees as well as to the offshore businesses.
Additional levels of employmentare attained when offshore banks also cater to domestic
banking and other services.These involvemuch larger volumes of operations with commensurate
direct and indirect revenues to the host government. Knowledge transfer is more significantand
can have positive impacts on the domestic financialindustry. The complexityof such operations,
however, also increasesthe complexityof the government's regulatory role. More involved
supervision and licensingprocedures are required, and measures are needed to prevent money
laundering.In addition, predictable monetary and exchange policy is crucial, given the parallel
operation of two markets which need to be segregated. In general, under all of the offshore
arrangements,the government is required to enforce the somewhat artificialbarriers between the
local market and offshore operations which deny access to local entities, and to prevent financial
flows between the two segments even though in practice, 'leakage' inevitablyoccurs to some
extent.
Development of the offshore sector should proceed in parallel with measuresto strengthen
detection of potential money laundering. The OECS governmentshave already signed on to
internationalmoney laundering monitoring agreements,and the ECCB is assistingin the
implementationof reporting formats for both domestic and offshore banks, which should provide
more detailed informationto monitor or detect abnormal movements in funds through the banking
system. Multilateralinstitutions and bilateral donors might assist in setting up twinning
agreementsfor ECCB with countries with related experiences. This could include early warning
mechanismsand detection techniques (includingthe requisite monitoring technology & links with
- 16 -
foreign regulatory authorities) and preventivemeasures against blossoming of illicit funds
channelingvia the OECS banking system.
Currently, OECS/ECCB area offshore banking laws differby territory, and no attempt has
been made to make these consistent under a uniform regulatory framework. While this is
understandabledue to the competitivepressures by each islandto provide offshoreinvestors more
favorable terms than those of other ECCB area territories, this 'go-it-alone' approach works
against the uniformbanking framework and sub-regionalintegration objectives.It is
recommendedthat for the establishmentof offshore banking,ECCB work with the sub-region's
governmentsto set out consistent requirementsfor supervision,for separation of these accounts
from the domestic banking system and for verificationmechanisms.This is also crucial in order to
avoid the inadvertent infiltrationof illicitfunds, which could severely damage the reputation of an
emerging industry.
g. Payment Systemsin the Banking Sector: As delineated more in detail in the payment
systems study which was conducted as part of the financialsector review, modernizationof the
banking infrastructureis fundamentalto the success of the anticipated reforms in the ECCB area
as well as to resolve some of the issues of fragmentation and fractionalizationof the industry. To
date, only one bank in the sub-region operates in each of the eight territories. Therefore, a large
proportion of paymentsboth inter and intra-territoriallyare effected via correspondent banks.
Clearinginter-islandcheques can sometimes take up to two weeks, and unavoidabledelays
generate credit and liquidityexposures among banks, thus augmentingthe risks to the system. The
objective shouldbe to reduce the cheque system to a minimumand increase the use of inter-bank
credit transfer systems,particularlyfor large and time-criticalpayments.In order to fulfillthe
plans for a singlefinancialspace and the developmentof capital markets to promote saving and
investment,the proposed securities markets for both government bonds and equities will require
the support of an efficientarea-wide payments system.
Some of the recommendedactions, elaborated in more detail in the payment systems
report, include (a) havingcommercialbanks establish a jointly-owned debit card switch linkinga
network of point-of-saleterminals and ATMs across the sub-region;(b) havingbanks establish a
joint direct debit scheme for the payment of regular bills; (c) havingthe ECCB establish a realtime accounting system to process and provide final settlementfor credit transfers between banks
throughout the day, and to handle all payments between ECCB and individualbanks including
those arisingin the securities markets; (d) havingthe banks explore a joint arrangementfor
clearing and settlement of cheques drawn in US Dollars on banks in the US, as a means of
reducing costs and delays under the current arrangements;and (e) having ECCB consider granting
settlement accounts to non-bank intermediariesin the securities markets, to ensure adequate and
reliabledelivery/paymentprocedures.
- 17OECS/ECCB AREA
STRUCTUREOF FINANCIALSYSTEM: ASSETS OF FINANCIALINTERMEDIARIES
Institution
Assets in $millions
% of total
CommercialBanks
5,860
72%
Social SecurityFunds
1,310
16%
Credit Unions
360
5%
DevelopmentBanks
260
3%
Life Insurance
173
2%
General Insurance
125
1.5%
8,088
100%
Total
Credit Unions
Credit unions are a dynamic and rapidly expandingpart of the financialsystem. They are
particularly important in sectors, such as smalland micro business, and in areas that have limited
access to commercialbanks. They are quick to expand their range of servicesto meet the needs of
their members. There are some 75 credit unions, with total assets of $379 million.A singlelarge
institution (in Dominica) accounts for almost $100 millionof this, while 58 "micro" institutions
have less than $5 millionin assets each. For about a third the credit unions, the common bond is
occupational;for the rest, it is communitybased. About 25% of the population are members of a
credit union (nearly 80% in Dominica). Consumer loans account for about half of their lending,
mortgage loans about a third, and the rest is loans to business and agriculture. However, many
loans classifiedas consumer or mortgage loans do in fact, go to finance smallbusinesses.
Fractionalizationand potential safety problems are of even greater concern here than for
banks. Some efforts are being made to address fractionalizationby encouraging amalgamationof
the smallestinstitutions and through the developmentofjoint institutions. Supervision,in the
hands of the Registrars of Cooperatives of the individualterritories, is not very adequate,
although efforts are being made by the Canadian-fundedCOOPS project to improve the
institutional capabilityof the supervisors.
Recommendations
Credit Union Operations: Fractionalizationamong credit unions is particularlynoticeable.
Although some steps are being taken in that national leagues of credit unions exist, the ECCB
should, via the nationalregulatory bodies, encourage credit unions to establisha central (subregional) institution along the lines of corporate central credit unions in the United States'. Such
an institutionwould push for self-regulatingfunctionsfor the sector, be managed solelyby its
members, and would accept deposits from credit unions with excess liquidity.It would be able to
invest the funds more profitablythan the individualcredit unions and it would aid integration
sCollaborationcouldpotentiallybe obtainedfromthe WorldCouncilof CreditUnions(WOCCU)based inMadison,
Wisconsin,U.S.A.
- 18 -
among credit unions and with the rest of the financialsystem. It would also provide individual
credit unions with a variety of financialservicesthat fragmentation and scale fractionalization
prevent them from providingfor themselves. These would, among others, include a central mutual
account where memberscould deposit excess liquidityfor the benefit of those with temporary
funding shortages. Financialsector oversight and regulation of credit unions should be
coordinated and consolidatedin order to achieve supervisioneconomies. The ECCB should assist
in this effort while helpingto strengthenthe supervisorycapacities of the area governments.
Development Banks
Seven of the territories have developmentbanks with total assets of $284 million.These
institutions, owned by governments,were traditionallya conduit for concessionaryfunds,
channeledto them through the Caribbean DevelopmentBank. As these funds have dried up, the
developmentbanks have turned increasinglyto other sources of finance, including Social Security
funds in a few cases. Their lending largely goes to finance projects of various kinds considered of
priority by the government;these include housing finance, and various sectoral industry projects.
About half their aggregate portfolios are in mortgage lending,both residential and commercial.
Given developmentbanks' roles of funding priority sectors which have long gestation
periods before payback, risks can be high, and on occasion some OECS institutions of this type
have suffered from high non-performingloan rates. On balance, however, some of the major
developmentbanks in the OECS have performed satisfactorily,and loans to the housing sector
have yielded reliablereturns due to the basic incentivesfor borrowers to ensure repayment.
ECCB's views on governance, management,funding, and regulation of developmentbanks point
to areas which have resulted in positive restructuring of this sector in other countries. For
example, despite the recent financialcrisis, the East Asian experience shows that the following
factors were critical for development banks to operate on a more commercializedbasis and
achieve solid institutions:
a. Using developmentbanks as non-recourse/no-guaranteeapex institutions for on-lendingto
commercialbanks at favorable terms for the developmentof new sectors;
b. Regular and thorough externalaudits includingperiodic determinationsof adequacy of the
capital base, strict limits on loan concentrations (both sectoral and client), potential equity
erosion, and strict policies for full write-off of non-performingassets;
c. High standards for professionalmanagement and technical staff (with competitivepay),
and appointment of independentand majorityapoliticalBoards of Directors with heavy
private sector representation;
d. Financialaccountingand lendingpolicies including aging criteria for non-performing
classification,in-depth up-front credit analysis(and skilled staff for this purpose),
conservativearrears ratios, and pro-active resource mobilizationand fund raising policies.
e. Linkage of loans to independent equity investments,and other financingparties,
f. Observanceof bankinglaws and prudential regulations commensuratewith commercial
banking practices,
g. Adequate funding against potential foreign exchange risks includingforex stabilization
funds and asset/liabilitycurrency matchingto the extent possible,
h. Implementationof fully modernizedinformationsystemsfor day-to-day loan account
monitoring and supervision.
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19
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One developmentbank in the OECS seems to be movingin the direction of
commercializationand possible privatization.
Recommendations
As mentionedearlier, government owned banks including developmentbanks should, to
the extent possible, operate according to commercialstandards, particularly for those projects
with rates of returns capable of repaying debt service. With respect to the proposed role of
developmentbanks as a 'window agencies' for brokering securities of OECS/ECCB area
companies (as part of capital market facilitationfor investors), this should be carefullyconsidered,
particularlywith regard to the impliedoperational aspects which might more optimallyshared
with the commercialbanking sector. While a developmentbank might serve as a government
sponsored nexus point at which to obtain over-the-counter data on securities availablefor trading,
the function of actuallytransacting trades becomes more complex. In this respect, it should be
considered that for the purchase and sale of securities, most investors, whether individualor
institutional,will be more likely to use commercialbanking servicesand engage in electronic
account debiting in order to purchase securitiesmore expeditiously.Such procedures will be even
more invaluableas capital markets develop, and efficientreal-time transactions are demanded to
ensure investor confidence.
If a developmentbank were to perform these functions,it would be required to open
deposit accounts (and thus be supervisedunder the Uniform Banking Act), which could lead to
growth in an area of businessthat they are not set up for (in terms of risk management of assets
and liabilities).While cash transactions could be possible, these proceeds would need to be
eventuallytransmitted electronicallyto the recipient of the funds, which again would depend on a
commercialbanking communicationsnetwork. Also, for safetyreasons, the carrying of cash by
customers would not be desirable,particularlyif purchases of securities were of large volumes.
Therefore, for the proposed function, it is recommendedthat at the outset, commercialbanks be
also permitted to participate in brokering securities,to ensure transactional efficienciesand
liquidityin the emerging capital market.
Regardingthe restructuring of the OECS development banks, the ECCB has identified
certain criteria, particularlyrelating to governance, management,and regulatory aspects of such
institutionswhich would ensure their long-run sustainability.Regulation of such banks as part of
standard banking sector supervisionwould formalizethe prudentialfinancialrequirementsof
developmentbanks and assist in standardizingtheir informationdisclosure. Such practices would
also permit these banks to eventuallybecome more independentlyfunded (e.g.: via own bond
issues),by attracting market investors relyingon standardizeddisclosure reports which would
provide comparableinformationfor making investmentdecisions.In this respect, the example of
the TrinidadianDevelopmentFinanceLimited bank (DFL) which issues its own bonds to fund
developmentprojects, would be a an interesting successfulmodel to examinein this context.
General Insurance
There are some 56 companies registered to transact general insurance business (roughly
one companyper 2,000 households). A few are branches or subsidiariesof large foreign insurers.
Some are government-sponsoredor subsidiariesof government-ownedfinancialinstitutions.
- 20 -
Some are subsidiariesof non-financialcompanies.Gross premiums were $108 millionin 1992
(2.5% of GDP). Assets were $125 million(mostly in the form of T-billsand time deposits).
The bulk of the businessis for real and related property with linkedcatastrophe coverages
(includingfire and natural hazard perils) under comprehensivehome and commercialpolicies -motor vehicles also constitute a significantshare of the business. Typically,up to 85% of the risk
is reinsured internationally.Local companies earn large commissionson reinsurancepremiums.
The sharp rise in these premiumsin recent years has greatly increased commissionincome and so
the profitabilityof the local insurers. Rather than this leading to competition to drive down rates,
it has instead led to the entry of ever smaller insurers and agents which manytimes do not add
productive value to the industry. The cost of catastrophe coverage is further inflatedby a variety
of taxes and impositions.There is a tax on premiums,a withholdingtax on reinsurance premiums,
required statutory deposits bearing no interest, and purchases of government securities at below
market rates. This policy seems to distort industry incentivesand diminishthe potential role of
insurance companiesin providingmuch needed capital to the financialsystem. Governments
should seriously considerreducing taxes on this industry. Surely, there is a powerful public
interest in encouraging people to insure.
The proliferationof small insurers is cause for concern regarding efficiency
(fractionalizationand economies of scale), but even more regarding safety. Are these small
companies sufficientlycapitalized for the 15% of the risk that they retain? Are they sufficiently
careful in choosing reinsurers that can be relied upon to pay up their 85% share? Regulation in
this sector needs to be substantiallystrengthened, and specialistswith underwriting and actuarial
skillsdeployed for the supervision function. Sinceregulation is in the hands of the individual
territories, there are some diseconorniesdue to the lack of institutional,technical, and
technologicalresources to effectivelymonitor and supervise.
Recommendations
a. FinancialReserves: Companiesand households should be encouraged to establish
financialreserves to supplement insurance or to cover losses that are uninsurable (such as
interruption of business). A possible idea is to establishtax-free savings accounts that could be
drawn upon only for casualty losses (the tax-free status of course would matter for households
only in those territories having a personal income tax). Financialreserves might also provide a
solutionto the problem of the notorious "2% deductible". Policyholderscould be offered a special
contractual savingsvehicle, enablingthem to put aside a certain amount each month until they
accumulated an amount equal to the deductible.A credit line could be associated with this
account so that they could "overdraw" if a loss occurred before they had accumulatedthe full
amount. Such a solutionwould be less expensive for policyholdersthan reducing the deductible
(informationwas received that reducing the deductibleto 1% raises the premium by 15-25%).
Governments,too, might consider establishingreserve funds that they could draw upon
for infrastructurerepairs. Of course, with a well-developedgovernment securities market and a
reduced reliance on external debt, they would also be able to borrow more easily for this purpose,
as needed. The Government of St. Kitts allows insurance companiesto accumulatea "catastrophe
claims equalizationreserve". Each year they may set aside 20% of premiumsbefore tax until they
have built a fund equal to 100% of premiums.This is an excellent idea and should be extended to
all territories. An added benefit of these various financialreserves, from the point of view of
- 21 capital market development,is that they would increase the volume of contractual savings
vehiclesin the area.
b. Industry Structure and Taxes: Two related changes in the industry would be highly
desirable:an increase in competition that would lower the cost of insurance, and a drastic
reduction in the number of small companies (to reduce fractionalization)in the general/casualty
business. The is not intended to achievethe largest size companypossible, but rather to ensure
that only prudent companieswhich can properly assess 'maximumprobable loss' liabilitiesand
accumulatecapital for it, be licensed. Supervisingthis requirement will place the proper incentives
in the industry and let primary companies self-regulatethe extent to which they delegate their
customer liaisonsto agents and brokers. One possibilitythat might be considered is to modify
reinsurance commissionsthat are proportional to reinsurancepremiums, with commissionsthat
are proportional to the value of the insured property. Commissionswould then no longer rise with
reinsurance premiums,which have the effect of biasing upwards the impact on the cost of primary
insurance-- this is the cause of the large profitabilitythat draws small companies into the business
but prevents adequate insurance capital accumulation.In addition, as noted earlier, the various
taxes and impositionson general insurance are inappropriate, because they raise its cost and
discouragethe purchase of adequate insurance. Taxes and impositionson premiums,catastrophe
reserves, and reinsurance premiumremittances should be substantiallyreduced and/or eliminated.
c. Supervisionand Safety: Certainly,much tougher prudentialstandards are indicated for
the domestic companies. As noted above, small and undiversifiedlocal companies are inherently
unsafe, particularlygiven the stochastic nature of catastrophic events. Apart from better
protecting policyholders, tougher standards might reduce profitabilityand drive out some of the
smallestcompanies and net commissionseekers. Standards should ensure an abilityto cover
maximumprobable losses consistentwith internationalindustry practice. Solvencyrequirements,
for example,merely ensure that assets cover the expected value of claims (reflectedin premium
reserves based on event probabilities),but they do not ensure that total industry capital reserves
can at any one time, cover maximumpotential liabilities.Supervisionof insurancecompanies
should be overseen by the ECCB to ensure that standards for prudency and reporting are
consistentlyapplied across the OECS/ECCB area.
A regulatory framework to put in place uniformlyacross the sub-region, should include:
(a) minimumcapitalizationfor domestic companies, (b) solvencyand liquiditylevels, (c) adequate
asset/liabilitymanagement and matching,(d) incentives(tax concessions) to build up catastrophic
reserves, (e) minimumstandards on non-ceded retention of local coverage, (f) proper valuation of
balance sheets to ensure capacity to cover claims, (g) allowancefor overseas investing of financial
assets, (h) verification of security of overseas reinsurers, (i) building code complianceto promote
uniformunderwriting standards, (j) developmentand implementationof monitoring and inspection
techniques, (k) conditions for revoking licenses and shutting down non-viable operations, and (1)
uniform one-timelicensing procedures for sub-regionalcompanies.
Social Security, Pensions, Life Insurance, and Links to Privatization
With $1.4 billion in assets, the surplus funds of the territories' social securityprograms
make them the largest financialintermediariesafter the commercialbanks. Social security
(national insurance)programs offer modest retirement annuities as well as survivor benefits,
worker's compensation,and health insurance.Participation is mandatory and the programs are
- 22 -
financedby payroll taxes. The programs are pay-as-you-go (i.e., they are not structured to be
funded for full retirement benefits accrued to-date by current participants if they were to retire
presently)but they have accumulatedsignificantsurplusesbecause both the plans and the
population are young. The bulk of the funds' assets are on deposit with banks and with other
financialinstitutions. The funds also invest in government securities and occasionallylend to
government-sponsoredprojects. Some Governments seemto regard them as a resource that can
be 'legitimately' used for government-favoredprograms. Most investments of social security
funds, however, are in fixed income instruments.There appear to be minimalinvestments in
equity, and bonds are held as the preferred long term asset instrument.
There is not much evidence of widespread public interest in contractual saving, beyond the
basic requirement:to a significantextent the family appears to fulfillthe role of smoothing
consumption.Beyond this, people seemto regard their contributionto social security and their
investmentin real property as a sufficientprovision for the future. The absence of a personal
income tax in some of the territories deprives contractual savings of any of the tax advantages that
enhance its attractiveness in many other countries.
There are 20 companies registered to transact life insurance business, with four foreignbased companiespredominant. The amount of life insurance is small:gross premiums of $38
millionin 1992 (0.9% of GDP); assets of $173 million.There has been some growth in the last
decade with the expansionin mortgage lending: mortgage borrowers typicallyare required to
purchaselife insurance. There has also been some interest in short-term policies geared to
financingeducation. For life insurancecompanies, mortgage loans are the most important asset.
They also hold government debentures, make policy loans, and have a small amount of private
placements.Life companies complainof the lack of attractive investmentoptions: low yields mean
high premiums, making it harder to sell insurance.Increased equity investments, both foreign and
domestic, would help mitigate these factors. The life industry is well consolidated-- the region is
represented by two major companies.
There are no statistics on private pension plans, but it seems that some large employers do
offer them (some plans are voluntary, others compulsory). Some plans examined,were defined
contributionplans; the nature of the others are not known. Pension plans do not appear
extraordinarilypopular with employees:in one case only 40 of 600 eligibleemployees participated
even though a 5% contributionby the employeewas matchedby a 7.5% contributionby the
employer.
Recommendations
a. Social Security Reform: Government directed investments for social security funds
should be restricted, and replacedby securities developed under the sub-region's capital market
initiatives. Since such funds are the only significantpool of contractual savings in the area they
shouldbe invested for maximumgrowth potential with minimalrisk. There are two options for
reform in this sector: one option would be to place the funds in the hands of independenttrustees,
for example,the trust department of one of the branch banks or large domestic banks. The
trustees would manage the funds in the best interests of the beneficiariesand invest based on a
private sector oriented growth strategy under prudential norms. The U.S. "prudent man" rule for
pension funds might be an appropriate guideline;there should be limited restrictions on the
purchase of foreign securities given their high asset growth potential and relatively low long-run
-23
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risk. Because of economies of scale, diversification,and reduction in fractionalization,it might
make sense to pool the social security funds of the differentterritories into a single fund. This,
however, would require a uniformlegislativeframework includingasset diversificationand
investmentguidelines. In any event, under any of these schemes,pension obligations should be
fullyfunded.
Another option for reform would be privatizationbased on the Latin American models.
That is, replace the current pay-as-you-go social security schemeswith mandatory individual
defined contributionretirement plans, together with purchased insurancefor the non-retirement
elements. (A reduced pay-as-you-go schemewould be retained as a safetynet.) Over time, this
would raise the national savingsrate and greatly increase the pool of contractual savings.Most
countries with mature pay-as-you-go social security schemesare facing serious problems with
them. Many are consideringprivatization.While the OECS territories with young plans and young
populations, do not face these problemsyet, they will eventually.This is inevitablegiven that the
traditional defined-benefitplans require periodic infusions of funds to assure that all future
liabilitiesare covered, and such infusions(when plans are not fully funded a priori) generallycause
fiscal drains or deficitfinancingby forcing funds to invest in lower yieldinggovernment paper.
Moreover, because the plans in the OECS are young and surplusesare currently large,
privatization now would be relatively easy.
Under the Latin Americanprivatized schemes(initiated in Chile), the Government issues
bidding invitationsto reputable international/regionalpension fund managers, to compete for the
financialmanagement of the beneficiaries' pension savings. During the transition process which
sets the cut-off date for the transfer to a private scheme, the accrued to-date benefits per
participant are determined. Once the cut-off date arrives, a cash or securitytransfer is made to the
selected private fund managers.For countries with a deficit funding situation, the transfer at times
is in the form of a government bond with a fixed maturity date.
A feature utilized recently in pension reforms in Bolivia, and which combinesthe Chilean
model with the Eastern European models of public enterprise privatization(with distribution of
vouchers for purchase of shares), is integratingthe public enterprise recapitalizationand
privatization,with the reform of the pension system. In this model, the capital markets are also
enhanced, and public ownership of company shares is immediate. The model, in summary,begins
by offeringprivate investors 51% of the shares of major public productive enterprises. The sale
proceeds (with contractual commitmentsfrom the investor) of the 51% is then reinvested into
such enterprises to improve their performance. Subsequently,the remaining49% is distributed to
the public as a future pension benefit. This 'benefit share' is eventuallyinvested/heldwith the new
private pension fund managers on behalf of the beneficiaries.During the transition process before
the pension fund managers are fully in place, the shares are held by a reputable Trustee company.
This company later becomes the custodianof the securities once the pension fund managers take
over the role of managing and investing funds and new contributions.In essence, the government
gives a free savingscontributionto the population as a method of diversifyingthe privatizationof
previous public enterprises. The strategic investors of course own a majority and controlling
stake, but the ownership still remains spread across the population, thus encouraging participation
in the capital market (i.e., by trading such shares, monitoring stock growth, etc.).
Some pitfalls to avoid in the creation of new equity markets based on some of the
experiencesin Eastern Europe, include a priori provision of safeguardswith a firm regulatory
- 24 -
framework in place, to prevent major problems such as: (a) transfer pricing of profits (i.e., related
entities buying or sellingshares to each other at artificialprices to better their financialcondition);
(b) lack of protection for minority shareholders(with takeover premiumspaid to majority
owners); (c) insidertrading; (d) greenmail(i.e., accumulatingshares in a target company and
resellingthose shares back to the company at a premium);(e) overchargingby brokers; (f) price
manipulation(included in some of the above); and (g) fund managers siphoningmoney out by
charging high fees for advertising, 'consultancy services', and public relations.
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25 -
PART IV
SECURITIESMARKETS
Government Securities Market
Total government debt amounts to some $2.5 billion-equal to about 60% of GDP
(indebtednessvaries significantlyfrom territory to territory). Of this total, $1.8 billion (70%) was
external. Some two thirds of the external debt was concessionary.Domestic debt consisted of
approximately$250 millionof T-bills, $350 millionof bonds, and $130 millionof (nonmarketable) loans from financialinstitutions. Marketable debt held by the public (that is,
excludingthat held by the central bank, social security funds, or other government agencies)
amounted to $270 million.An unknown proportion of this was held to fulfillvarious statutory
requirements.Consequently,the proportion of total government debt financed voluntarilyin the
domestic market was probablybelow 10%. The Finance Secretaries of the territories manage and
issue their own debt independently,with some advice from the ECCB. Instruments are threemonth T-billsand ten-year debentures. Statutes generallylimit the amount of T-billsto a certain
fraction of government revenue, and set a ceilingon the issue of debentures. Primary issue is
generallyby subscriptionat a fixedprice. There is no regular calendar of issue.
The market for government securities is highlyfragmented. Interest on govemment
securities is generallytax exempt in the territory of issue. This makes the government securities of
one territory relativelyunattractive for residents of another. It also makes government securities
relatively unattractive for individualsin the territories that lack a personal income tax.
Consequentlythe majority of the government debt is held by domestic financialinstitutions, the
remainderby non-financialcompanies. These investors regard government securities as a longterm investmentand routinely roll it over when it matures. There is consequentlyno active
secondary market. To make the market and these securities more liquid and tradable, a number of
constraints need to be surmounted including,insufficientmarketing,logistics of issuance,
settlement, & communications,and informationflow constraints.
Recommendations
a. Debt Management9 : To improvethe quality of government debt management,the
ECCB should augment its resources dedicated to monitoring this area, and consider establishing
an operational unit to track government debt (external and internal)for all of the OECS
territories. Under such a function, the unit, besides monitoring and accounting for government
debt, should set a clear goal in terms of minimizingthe cost of government borrowing with due
regard to risk (its guidelinescould be modeled on those of agencies in New Zealand and Ireland).
It should also be given considerablefreedom in selectingthe instruments(T-bills, notes, bonds,
maturities, domestic issuesversus international),the timing, and the issuance process as practiced
elsewhere by central banks acting as agents for the Treasury. Reliance on such a unit would still
require significantimprovementsin the departments of finance of the territories and would solely
imply an 'agency' function without any guarantees or presumptionsof credit enhancementfor
those government securitiesbeing managed. Each government would need to be able to anticipate
and plan their cash flow. They would need to provide timely and credible informationon the state
9
Many of these suggestions echo those of the IMF study (April 1996) and of the ECCB's own study (July 1995)
-
26 -
of public financesin order to establishtheir credit. Once a secondarymarket developed, this unit
could efficientlytransfer ownership of the securities to the purchasers via the book-entry method
(i.e., fully dematerializedsecurityrecord-keeping via computerizedbook-entry systems).
For this purpose, and also to modernize the regional government's fiscalmanagement
tools, the development of integrated computerized public financialmanagement systemsin the
OECS should be given priority, so that the functions of budgeting, debt management, cash flow
management,and accounting, can respond in a timely fashion to regional debt issuance
requirementsand market informationdisclosureneeds. Some substantialfiscal adjustments would
need to take place in the member countries before such schemescould become operational, in
order to avoid facilitatingless creditworthy countries from delegating their country/credit risk
managementto a central debt managementunit.
b. Primary Market: All government securities should be issued at market-determined
yields -- this will provide a market response as to the perceived credit quality of the issues.
Required purchases by government owned institutionalinvestors should be minimized,and the
current system of issue by subscriptionat a fixed price would be better replaced by some form of
auction. Tax and legal preferences for government securities and differentialtreatment across
territories should be phased out, as should all restrictions to the sale of government securities to
non-residents(OECS or others). If possible, a regular calendar of issues should be establishedto
enhance longer term liquidityplanning and funds management by financial sector participants. A
monthlyor quarterly auction might be appropriate, perhaps alternating among issues of the
differentterritories. The auction and the issue of the securities could be managed by the ECCB.
Its responsibilitieswould include offsetting any monetary effect of an issue, somethingthat was
apparentlya problem when the ECHMB was floated via capital contributionsby a number of
OECS financialand non-bank institutions.
c. SecondaryMarket: The planned call exchange could achieve intended benefits sooner
by emphasizingits role as a secondary market for government securities (indeed, it would
probablysee much more volume in these than in equities). An auction could be held as frequently
as trading volumejustified-perhaps weekly. If volume increased sufficiently,a dealer market
might eventuallyemerge, as banks found it worthwhileto become market makers. Any taxes on
securitiestransactions (stamp duties) should be abolished,as they are an impedimentto liquidity.
An earlierproposed idea for the ECCB to improve liquidity,was to issue its own paper
collateralizedby government securities -- this makes sense in terms of replacing many small
issueswith one larger one. It is, however, undesirable,because it would interfere with the market
determinationof yields. Such an issue by the ECCB would in effect constitute a guarantee by it,
of the underlyinggovernment securities, since a default on those securities would unlikely prompt
ECCB to default on its paper. A more promisingidea for improvingliquidityin the financial
sector, is the establishmentof a market in repos (repurchase agreements).A regular auction in
repos could replace the ECCB's current administered-ratearrangement.
Sincethe underlyingsecurities need to be of an acceptable risk rating, only the securities
of governmentswhose credit was in good standingwould be eligiblefor repo. The latter could be
neutrally determinedby deployinginternationallyrenowned bond rating agencies for this task to
provide confidencethat these are objectivelyrated. Alternatively,the ECCB could encourage the
development of a competitiverating servicesindustry which could in the interim, assess the
readinessof the area governmentsto be rated satisfactorilyby internationalagencies. Indigenous
- 27 -
ratingfirmsmightalso engagein cooperation/twinning
agreementswith someof the international
ratingagencies,as has occurredin numberof countries.For thosegovernmentsconsidered
eligibleby ECCBto issuepaper,the enhancedliquiditywould lowerthe requiredyield.The
existenceof a repo marketwouldfacilitateinterbanklending,and couldbe usedby the ECCBas
an instrumentof monetarypolicy.
MortgageMarket
Residentialmortgagesareby far the mostimportantlong-termfinancialinstrument:there
is some $1.3billionof mortgagedebt outstanding.Mortgagelendingis highlycompetitive.
Commercialbanksaccountfor 72%of the total, oftenthroughfinance-company
subsidiaries;
insurancecompaniesfor 14%;and the rest is dividedamongcreditunions,socialsecurityfunds,
developmentbanksandnon-bankfinancecompanies.Mortgagerates vary acrossterritoriesand
seemhighrelativeto U.S. dollarmortgagerates (11-12%versus7-9%).Thisis furtherevidence
of internalfragmentationand of segmentationfromthe U.S. dollarmarket,unlessOECSbanks
considerhomeloanborrowersto be of a muchhighercreditrisk than U.S. counterparts
(somethingnot confirmedbasedon the low defaultrates on mortgageloansin the OECS).A
secondarymarketinstitution,the EasternCaribbeanHomeMortgageBank (ECHMB),was
establishedrecentlyat the initiativeof the ECCBwithIFC support.A private-sectorinstitution,it
willpurchaseresidentialmortgagesfrom privateoriginators(with recourse),fundingitselfby
issuingbondsin the domesticmarket.It is expected,eventually,to fund some 10%of all
mortgages.Intendedto deepenthe capitalmarketsby recyclingandencouragingmoreliquid
longertermdebt,its successwillin largepart dependon the eventualvolumeand liquidity
generatedin this secondarymarket.
TheCapitalMarket
Presentlythe capitalmarketis limited.Some28 companiesare publiclyowned.The
designation"public"earliermeantthat a companyhad morethan 50 shareholders,thoughunder
the newuniformCompaniesAct,the designationof 'public' excludesthe minimum.
shareholder
number.In anyevent, 'public' doesnot meanthat shareswere soldby publicissue,or that they
are publiclytraded.Indeed,in most cases shareswere solddirectlyto investorsby the companies
themselves.Thereis no organizedsecondarymarketfor the shares,but companysecretariesand
bank trust departmentsare willingto brokeroccasionaltrades.The proposedover-the-counter
callexchangewould encouragestandardizationof informationdisclosure,moretrading
transparency,and potentialexpansionof the interestedinvestorbase.Of the publiccompanies,11
arebanksand financialinstitutions,9 are in manufacturing(processorsof agriculturalproducts,
quarrying,andbreweries),4 are utilities,and4 are tradingcompanies.The total book valueof
thesecompaniesis $500million.The largest,St. LuciaElectricityServicesLtd. (LUCELEC),has
a book valueof over $100million,while12 havebookvaluesof under $30 million.Apart from
governmentdebentures,ECHMBbonds,anda smallmarketfor privateplacements,there is no
evidenceof a significantbond market.
The capitalmarketis highlyfragmented.For most companies,their shareholdersare
almostexclusivelyresidentsof theirhometerritories.In most territories,AlienLandHoldingActs
requirenon-residentsto obtainpermissionto holdequitysecurities(includingminorityinterests)
in domesticcompanies,andthe lawsdefiningthe limitsfor these,vary. Informationis a major
barrieracrossandwithinthe islands,andthis increasesthe risksfor smallshareholders.The
-28 ECCB has a mandate to develop the area's money and capital markets. The establishmentof the
ECHMB (see above) was the first initiativecompletedunder this mandate. The ECCB is currently
planningan over-the-counter call exchange to facilitate trading in equities and debt. It is also
consideringan investmentbank / venture capital fund institutionunder a proposal for an Eastern
CaribbeanEnterprise Fund (ECEF), to provide funding, capital (and possiblytechnical assistance
& financialservices)to start-off new enterprises. Under the ECEF, some of the investment
ventures could possiblybe appraised and monitored by specifiedOECS developmentbanks. The
ECCB is also considering separately,the establishmentof a mutual fund unit trust, to pool shares
for easier access by the individualinvestor.
Recommendations
a. Capital Market Development:Developmentof the capital market should ensure the a
priori establishmentof reliable technology to effect real-time purchase/saletransactions reported
to all ECCB area territories, and provide reliable settlement procedures via the bankingsystem.
This is particularlyrelevant given the geographic separation of the ECCB territories which has in
part contributedto the market fragmentation. The recommendationsin the payments systems
study would be a first step in upgrading the electronic funds transfer mechanismsacross the subregion. Requirementsfor an over-the-counter exchange would also call for a centralized data
nexus (e.g. at ECCB) for the recording of all traded securities, their ownership and transfers
thereof, and decentralizedtrading stations connected via dedicatedtelecom links to ensure data
security.To lower costs initially,data transmissioncould take place over telephone lines, although
in the long-run, these are subject to capacity constraints and securitybreaches.
The ECCB should also focus its efforts on eliminatinglegal and regulatory obstacles to
such development.Any artificialstimulusof the market for certain financialinstruments such as
equities (for example,through tax incentivesor treatment in favor of equity over debt) should be
avoided. The ECCB should also avoid establishingan institutionalinfrastructure which will
depend on long-term subsidiesfrom the public sector, particularlysince such operations are
normally self-fundingthrough trading fees earned by market makers and brokers. Seed capital
maybe contributed by the public sector for the formation of capital market institutions (e.g.: for
initial non-recurrent fixed costs). Investmentunderwriters (e.g.: banks or reputable independent
financialagents) might be offered the role of disseminatingfirst time public offerings of new or
existingcompanies across the sub-region -- a test of the marketabilityof such shares would be the
risk underwriters were willingto assume by anticipatinga full subscriptionof the new shares.
As with dealers, their financialincentiveswould be in cashing-inon the bid/offer spreads.
However, underwriterswould play an important corporate governance role in ensuring that only
financiallyviable companies entered the market. They could also redistribute shares to individual
investors -- the same role envisagedfor the unit trusts (mutual funds), although the latter would
be utilized more for purchasingshares on the secondarymarket while the former would be for
initialpublic offerings. A robust regulatory framework ensuring prudent operation of such a
market and clear 'rules of the game', would provide the greatest stimulusfor market momentum,
and monitoring of such a market can be achievedvia relatively inexpensivetechnology to assure
timely settlement procedures and simultaneousreporting across the sub-region.
With respect to the proposed role for developmentbanks as informationnexuses, while
the informationproviding role might be easily implementedat such 'stations', any trading activity
-29 or securities transactions, would require a reorientation of such banks' operating functions
(deposit taking and commercialsettlement), and potentially require them to be supervisedunder
the Banking Act. Thus, the commercialbanks should also be involved in the infrastructural
arrangements early on, since they would inevitablyplay a larger role (at a minimumas brokers) as
the market develops and gains momentum.10
Apart from eliminationof legal, regulatory, and infrastructuralobstacles, the most
important thing that the area Governmentsand the ECCB can do to stimulatethe capital market is
to push ahead with the developmentof a market for government securities. The establishmentof
such a market would provide the initialvolume and infrastructurerequirementsto support modest
local activityin the private capital market. The potential for a domestic equity capital market in
the ECCB area will be very limited at first, particularly sincefamily-ownedenterprises will need to
move towards a 'public-ownership' philosophyand new enterprises will not develop quicklyuntil
more long term capital is made availableto them. Moreover, for reasons of risk and
diversification,particularlyinitiallyunder a low-volumemarket, developmentof a domestic
market should also be linked to the internationalmarket, albeit, with portfolio limitations (at the
individual,institutionalinvestor, and broker level) to limit capitaltransfers abroad into non-liquid
securities.
The plans for a mutual fund thus have the same implicationsas those for an equity market:
if trading is thin and there is little liquidity,the risk to individualinvestors is great (particularlyif
they need to sell quickly), and thus some access to foreign securities is desirable under such a
structure. Developmentof a mutual fund/unittrust structure should therefore be sequencedfor
implementationmuch after a securities exchange has started and other capital (e.g.: via ECEF or
privatizations) has become availableto increase the shares on the market. Protection of the
individualinvestor will not be assured until trading is of sufficientlyhigh volume to allow a
market-based price discoveryprocess to work, and to have availabletrading counterparties to
allow cashing in securities on demand.
For the planned ECEF, sufficientincentivesfor the funds managers (e.g.: placing their
own funds in the investmentsmanaged, and ensuring an arms-length separation between the
interests of the fund and those of the projects invested in) should be put in place to assure
successfulresults. In the case of the AfricaEnterprise Fund (AEF) financedby the IFC, some
useful lessons can be obtained. The AEF was set up with attention to cost efficiencyin managing
operations while maintaininga high quality portfolio invested in smalland medium enterprises.
The AEF is only funded by one party, i.e., IFC, and project appraisals are undertaken by IFC staff
in the field offices. IFC financingvia the AEF is limitedto at most 40% of a given investment,
with local investmentpartners expected to finance the remaining60%. In practice, the AEF has
only funded one third of the investmentneeds. Decisionmaking procedures and the
documentationprocess has been simplifiedwith standardizedinvestmentdocumentation and quick
processing once a favorable appraisal has been completed.
The AEF limits its funding to amounts rangingfrom US$100,000 - $1,000,000 equivalent
for project sizes ranging from US$250,000 - $5,000,000 equivalent. Investments by the AEF are
made primarilyon a loan basis although some investments are in equity as well as quasi-equity.
10Alsoseerecomnmendations
underPart m,CommercialBankcs(EquityHoldings),and recommendations
underthe
DevelopmentBanks,also in Part III.
- 30 Equity investments cannot exceed more than 30% of an enterprise's share capital. Quasi-equityin
the form of 'venture loans' have flexiblerepayment scheduleswhich can be based on a percentage
of sales, and would be convertibleto equity. This is used in a few instanceswhere taking an
equity positionmight be inappropriateand where it is more feasiblefor the operation's success if
debt service is low in the early years. Recently, the AEF's total investment authority was
increased from US$70 mn. to US$170 mn. Most loans are denominatedin foreign exchange and
require repaymenton those terms, therefore during appraisal it must be assured that enterprises
have accessto foreign earnings. To address domestic-marketventures, the AEF has started
offeringguarantees on foreign exchange risk -- under these arrangements,lending is usually done
via a local financialinstitutionthat onlends the funds, and an interest rate premium is charged for
the foreign exchange risk. The advantages of the AEF is that it does not have to operate with
numerous sources of funds with differing conditions,and its functionsare maintainedat a
minimum. A separate initiative,the Africa Project DevelopmentFacility(APDF) only provides
advice on project development-- this helps to maintaina separation of functions versus the AEF
financingrole, which assures better quality control and independentreview of proposals.
b. Privatization: The ECCB should also encourage member governments to privatize
state-owned enterprises includingbanks. The enterprises owned by governments- utilities,
financialinstitutions, and commercialdevelopments- are precisely the type most easily financed
and favored in the capital market (through both debt and equity). The sale of a controlling interest
to sub-regionalor foreign companieswith substantial capital is desirableto ensure sound
managementand protect the interests of local smallinvestors in such privatizations;in the case of
foreign companiesit is also desirable on grounds of risk-spreading.The question of why a foreign
companyversus a domestic company should be strongly considered does not pertain to the
perceived abilityof either. Rather, it pertains to the reputational liabilitieswhich experienced and
recognized internationalfirms can suffer if they do not properly manage such ventures. The issue
is one of optimizingincentives,and in such cases known reputable foreign firms generallyare
subject to higher performance pressures, and in many cases (e.g.: privatizationsin Argentina,
Chile, Bolivia and Peru) they are better equipped to infuse additional capital, staff, and technical
infrastructureto those companiesthey invest in. The same argument would hold for experienced
underwritingagents who could play a valuablerole in underwriting new shares of newly
privatized companies and subscribingthese across the ECCB area territories to achievemaximum
diversificationof new share owners. They would also, if they deemed such shares marketable,
ensure adequate financialdue diligencebefore these were placed on the market. Additional
discussionon the methods and market players in the privatizationprocess is also addressed in Part
III, under the Social Security reform recommendations.
c. SecuritiesRegulation: There are currently no comprehensivesecurities laws to regulate
registration, disclosure,conduct, listing requirements, or rules for trading. Strong securities laws
are a vital part of the Anglo-Americanform of corporate governance (this relies heavilyon legal
protection of investors and on hostile takeover as a form of ad hoc concentrated ownership). In
other, quite successful systems of corporate governance, notably those of Germanyand Japan,
securitieslaws are much weaker and play a less important role. Given the limited initialvolume of
a local capital market, an attempt to emulatethe Anglo-Americansystem might be more than is
needed. An argument could be made, however, that investor protection through strong securities
laws is also necessaryto attract foreign portfolio investmentcapital. As argued earlier, it makes
sense for local companies that are candidates for foreign portfolio investmentto access it through
the foreign market. In order to do this, the domestic capital market infrastructureand its
- 31 -
disclosure and reporting requirementsneeds to be sufficientlydeveloped to match already
standardizedinternationaldisclosurerequirements.Thus, the developmentof ECCB area
disclosurerequirementsmight need to be phased in slowlywith more rigorous requirementsbeing
mandated as the market gains volume.
Once the sub-region's securities are sufficientlyliquid,the expansionto foreign markets
(potentiallyvia listingson a CARICOM-wideexchange as a first step) could be smooth enough
after a phased adaptation towards internationaldisclosure standards. One example of the
'standards' issue is the LUCELEC flotation, which adopted stringent Canadian standards of
disclosurein order to be attractive to foreign investors. The LUCELEC flotation also shows that
private initiativecan be relied upon to select the appropriate degree of disclosure without deep
involvementof regulators. The imposition of complex and burdensome regulations on all issuers
of securitieswould add significantlyto the cost of issue, especiallygiven the smallsize of
potential local issuers and the large and indivisiblefixed cost of regulatory compliance.ECCB has
already begun initiativesto consider treatment of the entire OECS/ECCB area as one market for
registration and disclosure purposes and such a step should be considered of high priority to
facilitate expansion and integration of the area's securities market.
In order to manage these new regulatory functions a SecuritiesExchange type commission
will need to be establishedto monitor and oversee securities trading in the sub-region. The ECCB
area Governmentswill need to designate an agency, its location, and charter, in order to begin
organizing oversightfunctions once the market institutionalinfrastructureis in place. To avoid
setbacks experiencedin other countries in setting up SEC type agencies, it is important that the
technologicalcapabilitiesof trading and informationreporting systems(includingtelecom
transfers of transactions in real-time) be in place and operational to ensure effective oversight.A
modernized payments system will also enable such an agency to rely on the banking system
network to monitor securities transaction settlement procedures and their timeliness.Key
elementsand institutional structures to defineunder a transparent regulatory framework for a
securities market are listed in Annex 1, however, the complexityof disclosurerequirementsand
the overall regulatory framework should be rationalizedin order to encourage initialmarket
development.
To avoid further fractionalizationin the licensingof broker and dealers in such a market,
limited 'universal bank' functions for commercialbanks should be allowed. Certainly,the area's
banks would have comparative advantages in conducting brokerage activities (i.e., arranging
purchases and sales for a fee, without taking equity positions), particularly giventheir abilityto
simultaneouslydebit or credit customer's accounts and finalize/settlesecurities sales via a
modernizedpayments system across the sub-region. Dealer licensingof banks (with limitationson
1 should also be adopted so that they can perform
equity stakes as a percentage of their capital)"
market making functions.With well structured bid/offer spreads, banks will naturally have
incentivesto provide liquidityto securities markets provided that their risk positions are
commensuratewith fees earned on trading. The limits on fees charged, can be specifiedunder the
SEC agency's regulations -- such regulations should carefullyweigh the profit requirementsfor
"For this purpose, the limits of banks' holdings of a single company (currently under the Banking Act) should be modified to
cover multi-companyholdings as an aggregate share of capital, and a company should be defined to be any part of the same
holding company or cross-ownership structure.
-
32 -
intermediariesto encourage market activity, but also prevent excessive commission-seekingand
supply-drivenmarket turnover.
d. Leasing: The USAID study (1989) found leasing to be a promisingform of term
finance for the area. It recommendedthe removal of legal, regulatory, and tax obstacles. Leasing
could be utilized to encourage expansionin transportation intensive industries such as
construction and tourism. Leasing as an indirect form of long term financingof equipmentmight
include lease contracts for construction equipment,trucks, mini-vans,tourist buses, concrete
mixers or refrigerated trucks. Full recourse regulatory provisions on lease contracts would need
to be put in place, to ensure and enforce responsibilitiesfor equipment upkeep and maintenance,
and to specifydepreciation rights and responsibilitiesbetween the lessor and lessee. In addition,
for leasing to work, the OECS territories would need to implementuniform customs, importing
and taxation policies to allow for fair transfer and movementof capital equipment,as weli as
prompt enforcementand legal recourse for non-compliancewith lease conditions.
e. ECCB Role: As argued, the ECCB should focus its efforts on eliminatingcrosscountry/territory barriers to encourage private initiativein developingthe capital market.
Regulatory barriers such as differentialgovernmenttreatment of financialsector licensing
procedures, securitiesregistration & ownership, prudential capital (for non-bank companies) and
legal definitionsof foreign ownership, cause fragmentation and discourage market playersfrom
perceivingthe sub-region as a unified market with common rules. In terms of securities markets,
the ECCB should be supported in eliminatingownershiprequirementsfor securities to be traded
on an over-the-counter call exchange,thus delinking exchangetraded equities from alien landholdingrestrictions. In terms of sequencing,however, the ECCB should give priority, as
mentioned earlier,in developing an integrated and free domestic market in government securities,
and participatingas a fiscal agent and issuer on behalf of the area governments. Since this entails
the standardizationand harmonizedtreatment of a market developed via the government sector,
ECCB' s role in this process would help make this market more transparent and attractive to the
private sector. The proposed call exchange fits in well with this objective as a resource allocation
mechanism,once such standardizationis achieved and a secondarymarket becomes viable.
Government security secondarymarkets play a key role in providinga foundation and capital base
from which other securities can be financed and leveraged. The development of, and trading
activity for other securities (particularlycommercialfixed income instruments which use Treasury
notes as benchmarks, but equities as well), will likelybe limited without the existence of low-risk
and regularly issued government bonds.
As alluded to earlier, the ECCB can help instillbest practices in the implementationof an
integrated sub-regionalmarket by: (a) Acting as an agent for the Ministriesof Finance in the
auction and sale of government securitieswhile maintaininga clear separation between fiscal
operations conducted by ECCB for the Ministries,and monetary operations conducted by ECCB
to control the money and credit supplyin the sub-region;(b) Moving toward market-based rate
determinationby eliminatingthe concept of a pre-determined cut-off rate; (c) Ensuring that area
governrmentsprepare forecasts of liquidityrequirementson which to base announcementsof a
calendar of issuancefor government securities;and (d) Ensuring that if more than one bidder has
offered the same yield and all cannot be accommodatedin the auction, that the issue be allocated
in a pro-rata fashion rather than selectingbidders before the bid period ends. This will become
more crucialwhen the market becomes more efficientand bids are submitted closer to the
deadline.
-33 PART V
MARKET CAPACITY AND RISK CONSIDERATIONS IN
DEVELOPING A CAPITAL MARKET
In evaluatingthe potential for capital market development in the ECCB area, it is useful to
review the functionsof a well developed capital market in the economy. It is commonlybelieved
that the principalrole of a capital market is to mobilize savings and channelthem into business
investment.This is a primaryfunction but not the only one. As we have seen, capital markets play
an importantrole in spreadingrisk: thisfunction is no less important than their role in mobilizing
savings. Second, in mobilizingsavings, equity markets play a relativelyminor role in funding
businessinvestment. The followingreflects financingpractices in both emerging as well as
developed capital markets:
(i) Business investmentis mostlyfinanced with internalfunds. This is particularlytrue in
developing economies.External funds provided by the financial systemplay a relativelyminor
role;
(ii) Generally, the main source of external funds is not the capital market but commercialbanks;
(iii) To the extent that the capital market does provide funds for business investment,it is mainly
in the form of bonds rather than equity. Disclosure and other legal requirementsare generallyless
costly for the purposes of obtaining debt versus issuing equity;
(iv) Most of the savingsmobilizedby capital markets do not financebusiness investmentbut
rather, government borrowing and investmentin housing.
An assessment as to the potential for a capital market is based on three factors: (a)
potential issuers, (b) potential investors, and (c) an enablingenvironmentfor bringingtogether
borrowers and investors in a local capital market structure.
Potential Issuers
There are two types of potential issuers -- state-owned enterprises and private firms.
Privatization of state-owned enterprises has been a major cause of the expansion of stock markets
in the developed economies as well as in many developing and transition economies. Indeed, a
number of existing publiclytraded companies in the OECS are the result of partial privatization
(most notably, the largest of them, LUCELEC). Additional privatizations are a promising source
of potential issuers for the capital market, and the OECS has a number of state-owned enterprises
which could be good candidates.A key policy issue of course, is whether governments are willing
to privatize. If the ECCB area governments are not willingto fullyprivatize public enterprises and
government owned financialinstitutions, they should at a minimumconsider selling off sufficient
shares so that the majorityownership of such entities ends up in the private sector.
To assess the second potential source of issuers - private companies - one needs to
examinethe nature of the OECS economies. Agriculture will be facing increased competitive
pressures, and, because of scale, there is limitedpotential for high volume manufacturing
concems. Strong prospects for growth as evidencedby recent trends, exist in services,including
data processing, accounting, banking,health services,and especiallytourism, the latter due to its
natural comparative advantage in the region. As the area's economies grow and incomes rise,
commercialand residentialconstruction are likelyto remain important. Term finance,therefore, is
- 34 -
likelyto be needed mainlyfor residential and commercialstructures, for hotels, and for
infrastructure.Finance for such purpose is best provided through secured debt. This means
mortgage lending by financialinstitutions and to some extent bonds for commercialventures. (The
current structure of the capital market conforms quite well to this pattern). Equity finance, as the
ECCB has documented,would primarilybe needed for smallmanufacturing concernsprovided
that they are willingto diversifythe ownership structure in smallbudding ventures.
A strong marketingand educational campaignwould be required to raise the prospects for
smalland mediumprivate companies to issue equity in order to start-up and expand. This is based
on the nature of private companies in the area. The typicalfirm is a familyenterprise engaged in
trading and/or distribution. Such firms are initiallyunlikelyto turn to the capital market for
finance. There remain strong incentivesto avoid open scrutinyby the tax authorities and this
factor makes them hesitant of the disclosurerequired for a public issue. For similarreasons, such
firms generallylack the necessarydetailed financialrecords. As mentioned,they are unwillingto
give up control to outsiders. Because of the obstacles to cross-border expansion mentioned
above, they do not face investment opportunities of a scale that would make tapping the capital
market a viable venture.
Thus, making more uniform regulations and promoting cross-border investments in the
area, would be a key pre-requisiteprior to generatinga market mentalitywhich would perceive
value in the use of equity instruments. Otherwise, the same obstacles that prevent budding
enterprisesfrom growing to a critical mass would also make access to a sub-regionalcapital
market more difficult.Currently, withintheir limitedhorizons, internal funds are generally
sufficientfor any planned expansion,albeit, at a fraction of their total potential. For those firms
which are already "public" in the informal sense, the shares being held by the public are generally
not very liquid. Thus a campaignfor adoption of sub-regionalintegration both in the financialand
real sectors would need to proceed at an accelerated pace before current 'public' companieswill
consider issuingadditional shares. From a sequencingstandpoint, this step would need to proceed
with urgency, while regulators, governments, and the ECCB work to streamline and harmonize
legislativeprovisionsgoverning investment,property, labor laws, and capital mobility.
Potential Investors
Outside investors in capital-market securitiesrequire the existenceof corporate
governance mechanisms- "ways in which the suppliers of finance assure themselves of a
reasonable return on their investment." The two principalcomponents of corporate governance
mechanismsare legal protection and concentrated outside ownership (i.e., the presence of outside
investors with a large enough stake to enable them to monitor managers and special interests). In
the ECCB area, legal protection needs to be substantiallystrengthened: securities laws and
securitiesregulators need to be put in place. Foreclosure is often difficultand delays in the legal
system hamper the enforcement of debts. In many countries, banks play the role of concentrated
owners, however, the allowancesfor banks holdingequity need to be revisited while setting out
prudential limits on their equity holdings against total capital. Foreign or regional strategic
investors are a possible source of concentrated ownership for privatizedstate-owned enterprises
which could eventuallylead to a more liquid equity market; this mechanism,however, would not
apply to the typicalprivate company.
-35 -
There are two categories of potential financialinvestors - institutions and individuals.
Given the lack of corporate governance mechanisms,the former are more promising,since
institutional investors can themselves act as concentrated owners. Of potential institutional
investors, we have seen that contractual savings institutionsin the area (life insurance companies
and private pension funds) are of only minor importance. The social security funds, however,
could have significantpotential, but to realize it they need to be fundamentallyreformed and given
more autonomous investmentdecision makingto select among a range of investable securities,
includingthose on the internationalmarket. Prospects for attracting foreign institutionalinvestors,
however, are limited currently:local companiesare too small,their securities are not liquid, and
corporate governance mechanismsare not in place.
The potential for individualinvestmentwill be limited initially.Local small investors are
conservativeand cannot avail themselves of reliable data with which to assess potential
performance of companies. They prefer real estate and bank deposits, and regard shares with
suspicion (no doubt reinforced by the recent crash in Jamaica). The absence of effectivecorporate
governance mechanismsis especiallytroublesome for smallinvestors. The one thing that could
bring smallinvestors into the stock market in large numbers is a speculativeboom. Such an event
may or may not be desirable, but it would generate the necessary demand for a regulatory
structure to oversee corporate governance, and the technologicalcapabilitiesfor ensuring efficient
and transparent trading throughout the ECCB area.
Historically,of course, it is the wealthy rather than smallinvestors who have invested in
the capital market. In the ECCB area, however, the wealthy tend to be entrepreneurs rather than
rentiers, and they have better use for their resources in their own businesses.Nevertheless,
diversificationmight make financialinvestments attractive if the yieldswere sufficientlyhigh, and
if they were sufficientlyliquid.
An Enabling Environment for a Capital Market
There is some potential for issuers (mainly privatizations)and for investors (mainly
reformed social securityfunds, but also potentiallybanks and insurance companies). Given this
potential, the opportunities and constraints need to be identified and SWOT analysisapplies well
for such an assessment (Strengths, Weaknesses,Opportunities, and Threats). In terms of
strengths, current investableinstrumentsare mainly fixed income -- these have limitedgrowth
potential, and most institutionalinvestors will welcome more portfolio choices, provided that they
have a sound commercialbasis. Potential borrowers or issuers of equity, particularly small
enterprisesmight actuallyfind it less costly to finance equity than debt, provided that investors are
well informedof trade-offsbetween high dividend income and capital growth. In terms of
weaknesses, there are two arguments against it: risk and scale. As we have seen, a key function of
the capital market is to spread risk. If local investors invest in local securities, the capital market
will not perform this functionwell. From this point of view, local investors should diversifymore
into foreign securities and foreign investors in local securities. The risk spreading role will not
materializeuntil commercialconcerns develop to a sufficientcritical mass to generate substantial
volume of equity trading throughout the sub-region.Even under such circumstances,due to the
region's exposure to natural hazards, it would be prudent to diversifyinto international
investments.
-36 Opportunities are a key variable in planning for financialsector development. As discussed
earlier,the main opportunities which cannot be missed, are the harmonization of the area's
regulatory frameworks to integrate cross-border businessactivity via uniform one-time
procedures for registration and licensing of financialinstitutions and enterprises. Making
consistent tax regulations governing security income, and reforming/repealinglimitationsin the
AlienLandholdingActs, would open up the field for cross border investmentand lending. These
opportunities should be supported by early development of modern payment systems and efficient
informationsystems for monitoring capital market activity across the sub-region. Threats to these
objectivescan be expected: industriesin some territories may lobby against fall integration to
ensure protection if they are not competitive.Governmentsmay not wish to antagonizetheir
constituents by letting in outside players that would weaken traditional public/private
partnerships.Liberalizationmight mean giving up some revenues earned on differentialtax
treatment of outside investors, although conversely,it may increase revenues from additional
corporate income brought into the local market. While it is likelyand possible that some
consolidationof industries (both financialand non-financial)will take place, the overall cost to
society should decrease -- this in itself will mobilizeadditional savings which can be redeployed
for the generationand expansionof domestic investmentventures.
The potential scale of a local capital market will initiallybe small,however. This could
implyrelativelyhigh costs in the initial creation of the necessaryinfrastructure. It also means that
a secondarymarket would be unable to provide initially,liquidityand price discovery. A call
exchange in itself needs to cover its transactions and overhead costs to remain profitable.If
trading volumes are low (somethinglikely, given current experience of illiquidinformal equity
markets, and limited secondarymarket debt instruments),the fees and commissionsearned from
trades will not generate sufficientincome to finance the operating costs of the exchange. This
could result in a government subsidizedcall exchange which would need to be phased out
eventually.This again points to a sequencingissue: regulatory harmonization and liberalization
needs first attention. This should be coupled with a broad and continuous educational and
'marketing' campaignon the benefits of capital market instruments and regional integration. The
outcome of this phase will dictate at what point the appropriatetrading infrastructure should be
implemented.Initiallyan over-the-counter market would seem to make more sense, giventhe
relative ease with which technology can be adapted to such a structure. A centralized call auction
exchange would only make sense at a later stage, once the shares offered on the market had
grown sufficiently.
To facilitatethis process, some key reforms would be in order: State-owned enterprises
would need to be privatized to develop a critical mass of equity offerings. Foreign strategic
investors should be encouraged (as large shareholders)to provide confidenceto the market and
encourage individualinvestors to take equity stakes. As mentioned before, due to high-stakes
reputationalfactors, such strategic investors are more likely to add some of their own capital and
ensure that privatized entities perform. The remainingshares would be sold to local and subregional investors. Smallercompanies would eventuallyregister on the exchange. Larger
companieswould also raise debt through bond issues, and these could subsequentlybe traded on
the exchange. To link the OECS/ECCB area capital market to the internationalmarkets, securities
could be pooled into mutual funds whose shares might be listed on a regional or international
exchange.The dual function of mutual funds (unit investmenttrusts) to encourage international
portfolio investors as well as individualdomestic investors, would provide them additional
- 37 -
momentumto develop, rather than limitingsuch conduits solelyfor the use of local small
investors.
Domestic institutional investors, principallythe reformed social security funds, should hold
well-diversifiedportfolios that contained both local securities and foreign securities.While holding
of foreign securities could be limitedto between 30%-60% of a given defined portfolio, it should
be up to the individualinvestor to select from a variety of options what allocation of assets and
instruments should be designed, provided that they the meet prudential safeguards and foreign
securities limits. This in effect would to some extent spread the region's foreign exchange
holdings into the private sector, but the risk reduction effects of holding highlyliquid marketable
internationalsecurities (not correlated with OECS financialor economic swings and/or with
economic shocks from hurricane events) would greatly outweigh the risks of concentrating all
portfolio investmentsdomestically,even if diversifiedwithinthe OECSIECCB area. It would also
serve to attract highlyskilled nationals outside of the region, given their incentive of being able to
maintain domestically,a highly diversifieddomestic/foreignportfolio.
Internationally,the experiencehas been (e.g. Chile) that countries with good
macroeconomicperformance greatly benefit from more liberalizedcapital flow regulations.
Potential capital flight can also be mitigated by regulating phased introductions of foreign
investmentallowances, as well as restrictions on short-term foreign speculativemovements of
funds in and out of domestic accounts. This can include restrictions on minimumelapsed times
(e.g.: annually)for large external investment of capital in the region, before such investments are
unwound or liquidated,as well as phased in allowances of portfolio shares permitted for overseas
investment.Foreign direct investment (FDI) would continue to be a key element in the integration
of the area into the internationalcapital market. With further removal of barriers, it would be
expected that some local companieswould themselvesengage in sub-regionalFDI, investing
directly in other territories and more broadly in the region.
- 38 PART VI
CONCLUSIONS& OTHER ISSUES
In light of the foregoing,the principalconclusionsas reflected in the recommendations
elaborated earlierin the report, are as follows:
- The ECCB and the area Governmentsshould focus its efforts on removing obstacles to
private financialactivity. These should include the harmonization of legal and regulatory
differencesacross the OECS/ECCB sub-region,in the areas of financialinstitutionlicensing,
prudential requirements(for non-banks), and landholdingrestrictions which affect equity
securityownership. The ECCB should also work with member Governmentsin order to:
* Reduce public sector involvementin the financialsystem and promote private sector led
initiatives, e.g., by banking, insurance, and other associations;
* Remove obstacles to financialintegration in terms of differentialtaxation and establishonetime simultaneousregistration procedures for financialinstitutions qualifiedto operate in any
of the member territories;
- Encourage through facilitatingregulations and to promote financial strength, the
integration and consolidationof the domestic banks and the general insurance industry across
the region. Such integration would help to diversifygovernment owned institutions into the
private sector, and absorb financialmarket players that have non-performing,high liability
portfolios, or low value-addedin terms of their capital contributionto the sector. This would
also result in lower transactions costs for both institutions as well as individuals.
. ECCB should work closely with the member Governmentsto establishan area-wide
market for government securities.
ECCB - INSTITUTIONALISSUES
Bank Safety and Supervision
The ECCB needs to think through how it would respond to possible systemicproblems. Is
it prepared to act as a lender of last resort and should it fulfillthis role. To act as a lender of last
resort, a central bank "creates money" and lends it to illiquidbanks (although only against good
collateral). This enablesthe banks to meet their depositors demand for withdrawals.With a
currency board approach, however, the ECCB is limited in its abilityto create money. A rough
calculationindicatesthe amount of money creation that might be needed in the worst case.
Demand deposits in the area total about $830 million.Perhaps two thirds of these are at branch
banks, which should not require assistance.Of the remaining$280 millionat domestic banks,
about half is covered by cash and by deposits at the ECCB. This leaves about $140 million.Given
the ECCB's currently high coverage of external reserves, it could meet this amount without
fallingbelow its 60% minimum.However, questions remain. How much is it authorized to lend to
banks in an emergency?What would it do if its coverage were closer to the minimum?What type
of collateralwould the ECCB be willingto accept against its lendingto banks?
- 39 -
Beyond its function of lender of last resort, is it the policy of the ECCB to guarantee the
deposits of commercialbanks? It should not be. An appropriate concern on the part of depositors
about the safety of their deposits is an enforcer of bank discipline.Depositors considerthe branch
banks to be somewhat safer than the domestic banks. This exerts pressure on the domestic banks
to behave in ways that instill confidence-- including integration and consolidation.Due to the
potential liabilitiesand moral hazard, deposit insurance would be recommendedbut only for
extremelylimited amounts of coverage, so as to protect small individualdepositors while forcing
large corporate account holders to monitor bank managementmore actively.Explicit but limited
insurance would also promote more self-regulationamong banks, since they would no longer be
able to count on depositor bail-outs beyond explicit coverage limits set a priori. Latest thinking
and considerations on this issue have led to the conclusionthat no deposit insurance whatsoever,
can lead to additionalmoral hazard problems sinceexpectations of some, albeit undefined, levels
of guarantee for certain classes of depositors will alwaysbe expected from the government. This
occurs due to the political/economicconsiderationswhich emerge during bank crises and which
frequently lead to regulatory forbearance when ex-ante rules have not been concisely defined.
Based on the experiencesof a number of countries in Latin America and elsewhere,
implementationof early warning systems and more real-timemonitoring of the banking sector
would be advised (e.g.: via on-line weekly or semi-monthlyaccess to banks' financialcondition).
This could be arranged with World Bank support to broker special twinningarrangementswith
supervisoryauthorities from the U.S. or other countries, which have developed timelymonitoring
techniques and preventive measuresfor such crisis instances.Exit and/or takeover policies for
banks in distress, would also need to be developed and definedmore clearlyto ensure prompt
action in the event of crises.
Supervision and Regulation of Non-Bank Financial Institutions
The ECCB should assist in setting standards for regulation and supervisionfor all financial
institutions in the area. Currently, regulation and supervision of non-bank financialinstitutions is
the responsibilityof the individualterritories. Their performance of this functionis generally
lacking of adequate institutional and technical capacity. This is not at all surprising given their
small size and the large fixed costs of establishingan effectiveregulatory framework on a countryby-countrybasis. It makes little economic sense for them to performthis function in isolation, and
the task should incorporate efficienciesof informationand reporting standards, which could be
'brokered' by the ECCB. The ECCB has already established institutional competence in its
supervision of the banks and the economies of scope in coordinatingsome of these cross-border
functionsare obvious. As with banking supervision,the ECCB would need to ensure a strict
separation between its monetary functions and any fiscal-related initiativesin these areas.
Specifically,the ECCB should assist in acceleratingthe process to develop uniform laws
to be passed by the territories for the various sub-sectors includingcredit unions, insurance
companies, offshore banks, and securities. Although currently there are few pension funds and no
investmentcompanies (mutual funds) it would be wise to be prepared to supervisethese types of
institutionstoo. For these various sub-sectors in the financialindustry, a number of regulatory
framework models and associated financialprudency indicators have been developed in line with
current internationalstandards. The World Bank can support ECCB in identifyingrecent work or
best-practice legislationin this regard, which might be best suited for applicationin the OECS.
-
40 -
Monetary management'2
The current administeredrepo arrangement and discount window could be replaced or
complementedwith a "Lombard facility",i.e., a straightforward short-term lending facility.Banks
should be free to borrow (against suitable collateral),but at a higher than market rate. The rate
should be set at a significantmargin above the market-determinedrepo rate. This discount
window would be a passive instrument of monetary management, although the ECCB could use
the size of the margin as a policy instrument. The ECCB could use direct intervention in the repo
market as an active instrument of policy.
Other ECCB Functions
Research and Statistics: The ECCB should gather informationfrom employers on pension
plans. It would be useful to know how extensivethey are, to what extent they are funded, and
how the funds are managed. The ECCB might consider conducting or commissioninga survey of
consumerfinances to gain some insight into household saving and investmentbehavior.
Tourism is criticallyimportant for the region. A section in the research department devoted to this
sector would seemto be a good investment.
Education: The ECCB has a program to develop and implementcomprehensiveeducation,
awareness, and training programs to enhance financialliteracy in the ECCB region. This is
important and should be continued. There is a need to encourage pension saving and insurance
even in fully developed countries. People everywhere seem to find it hard to make good financial
decisions when they involve the distant future or events with a relativelylow probability.Media
and public informationcampaignstargeted towards individualsand smallbusinessesshould also
be part of this educational process.
WORLDBANK SUPPORT
In support of these recommendationsthe World Bank Group could consider the foliowing
projects:
Technicalassistance to the ECCB in developingthe government securities market, and
technical assistance to the ECCB to help it develop, coordinate, and establishuniformityin
regulations and supervisorypractices across the sub-region for non-bank financialinstitutions.
c
*
Technical assistancewith legal and regulatory reform to facilitatefinancialintegration
within the area and with the internationalfinancial system. In particular,this should cover (a)
uniform licensingand operating requirements, (b) disclosure requirements and involvementof
experiencedinvestmentadvisors for the floating of new capital market instruments, (c) financial
and legal procedures for carrying out mergers and associated balance sheet restructurings, (d)
portfolio risk assessments in the banking and insuranceindustriesto ensure adequate prudential
capital in line with intemational norms, and (e) technologicalrequirementsfor modernizationand
cross-border integration of financialcommunicationsand information systems(also see payments
system report).
12
Recommendationshere echo those of the IMF study (April 1996).
-41 -
A study of options for social security reform includinghybrid public/privatesystems, fully
privatized systems,:and privatizationvoucher systems linked to distributionsof pension benefits.
Related to this would be a study to recommend a program of privatizationand due diligence
methods for evaluating equity worth, preparing bidding procedures, and setting out transparent
rules for transfer of ownership and performance targets.
The IFC might potentiallyprovide technical assistance to the domestic banks for their
joint/mutual initiatives, and for developmentof an enterprise venture investmentfund.
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ANNEX 1
Regulatory Elements for the Functioning of a Securities Market
I. For Market Transparency Purposes: (a) A public registry for securities; (b) Registration
and information disclosure requirements; (c) Exclusions from registry requirements; (d)
Privileged and confidential information.
II. For the Public Offering of Securities: (a) Initial public offering procedures; (b) Offerings
on the secondary market; (c) Public offering of securities currently traded on the private
market; (d) Bidding and purchasing methods; (e) Exchanges of equal-value securities; (f)
International offerings.
III. Ownership Transfers and Records for Tradable Securities: (a) Electronic and book-entry
systems (b) Certificate transfers, (c) Classifications for notes and bonds; (d) Classifications
for short term instruments; (e) Classificationsfor equities; (f) Preferred
instruments/subscriptions; (g) Other instruments.
IV. Securities Negotiation Mechanisms: (a) Call exchange procedures; (b) Unlisted exchange
procedures; (c) Over-the-counter procedures; (d) Other electronic and dealer procedures; (e)
Suspension of trading; (f) Exclusions from the market.
V. Central Stock Exchange Procedures: (a) Functions and responsibilities; (b) Authorization
for organization and operation; (c) Internal statutes and by-laws; (d) Membership procedures
and requirements; (e) Board of Directors and Management; (f) Guarantee Fund; (g) Fee
setting for membership and trading activity; (h) Specialist and market maker traders; (i)
Dissolution and liquidation conditions.
VI. Agents and Interrnediaries: (a) Stock exchange agents; (b) Capital and guarantees; (c)
Operating conditions; (d) Representatives; (e) Subsidiaries; (f) Intermediaries/Dealers of
Securities.
VII. Execution and Settlement of Trades: (a) Securities listed in book-entry form; (b) Central
Repository of Securities; (c) Custodian Institutions; (d) Settlement agents; (e) Cash and
margin requirements/limitations; (f) Trading based on collateral.
VIII. Mutual Funds (Unit Trusts) and Administrators: (a) Securities investment funds and
definitions; (b) Investment guidelines and disclosure; (c) Share values - market accounting
standards; (d) Disclosure requirements; (e) Minimum capital; (f) Load, asset management
and expense fees; (g) Open and closed-end funds; (h) Exclusive pension funds; (i) Allowable
debt; () Intervention, dissolution and liquidation.
IX. Securitization Procedures: (a) Securitizable assets and backing capital; (b) Priority claims
of assets on securitized instruments; (c) Trustee arrangements on securitized instruments;
(d) Offer and pricing of securitized assets.
X. Dispute Resolution Mechanisms: (a) First instance call exchange arbitration; (b)
Regulatory authority arbitration and degree of materiality; (c) Judicial arbitration;
(d) Definitions of impropriety and manipulation; (e) Sanctions and penalties.
- 44 -
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2.
ECCB, Commercial Banking Statistics, June 1996.
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4.
ECCB, Economic and Financial Review, March 1996.
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