Jamaica financial institutions will have to take on 12.5 per cent of the risk of GOJ foreign currency debt that they hold come month end, as the Financial Services Commission (FSC) moves towards regulation that requires local firms to take on the full risk by end-March 2012.

“The risk weights assigned to GOJ debt denominated in foreign currency are to be increased in a phased manner to the 100 per cent required by Basel, while the regulators still retain their national discretion in assigning a zero weight to GOJ domestic debt instruments payable in domestic currency,” FSC deputy executive director, George Roper told the Business Observer.

To cover the risk, these firms will have to have a capital base that, at minimum, covers the cost of eight per cent of the value of its holding of the bonds. As at March 31, 2010, the Jamaican government had US$3.2 billion worth of global bonds and over US$1.2 billion of US dollar and US dollar indexed bonds in issue.

At end December 2009, according to the Bank of Jamaica (BOJ), Jamaica’s financial system had a total capital base of $80.7 billion — equivalent to over 20 per cent of the total value of GOJ global bonds and US dollar and US dollar indexed bonds.

Presently, domestic firms are not required to have the capital that covers the risk associated with these bonds.

Roper said that beginning June 30 the risk weight is scheduled to increase by quarterly increments of 12.5 percentage points to give banks time to adjust their capital portfolio accordingly.

Concerns have been raised from the banking community that the measure may be too stringent and could squeeze some smaller players out of the market. One financial firm boss said that the sovereign bonds should not have the same risk weighting as equities, or real estate. He argued that the bonds present significantly less risk of default than either of the two forms of investment and that as such the 100 per cent weighting is not appropriate.

Roper concedes that the comparative weighting under these conditions are not “perfect”.

“No one can definitively say that the schedule of risk weights perfectly captures the comparative differences in credit risk across the entire spectrum of asset classes,” Roper said. “However, to the extent that the risk weighting regime errs on the side of conservatism in the classification of GOJ foreign currency debt instruments, then the financial system is made safer through financial institutions meeting the higher capital requirements.”

Even then, Roper said that the terms of implementation are flexible so “that financial stability is not compromised by the reform”.

The 100 per cent increase in the risk weighting on the GOJ bonds are consistent with the standards of the Basel 1capital adequacy framework to which the FSC subscribes, explained Roper. He said banks in Jamaica are subject to this standard based on Bank of Jamaica requirements and FSC guidelines on interim capital standards.

The Basel 1 is a set of international banking regulations that set minimum capital requirements of financial institutions with the aim of minimising credit risk. The standard stipulates risk weightings of between zero and 100 per cent for OECD and non-OECD government and bank debt. Under Basel 1, banks that operate internationally are required to have a minimum capital equivalent to eight per cent of the risk weighted assets (RWA) while local firms are currently not required to include GOJ foreign currency debt in the RWA mix.

“Within the Basel 1 framework, all non-OECD country sovereign exposures payable in foreign currency are to be assigned a credit risk weight of 100 per cent,” said Roper. “Jamaica is a non-OECD country, and therefore, GOJ debt instruments held by financial institutions should, strictly speaking, have been assigned a risk weight of 100 per cent”.

He said this was not done before because Basel I gives national supervisors discretion in the application of risk weights.

“Historically, the financial sector supervisors (BOJ and FSC) have exercised this discretion in assigning a zero risk weight to GOJ foreign currency denominated debt instruments, similar to the zero risk weight applied to GOJ domestic currency denominated debt instruments.”

However, with the ‘selective default’ which characterised the GOJ’s Jamaica Debt Exchange (JDX) programme in February, GOJ global bonds attracted a higher risk weighting. Additionally, Jamaica’s Standby Arrangement with the International Monetary Fund (IMF) required structural policy reforms of the financial sector. Strengthening capital adequacy was one such recommended reform.

“Against this background, it was considered prudent to revise credit risk weights for the purposes of computing minimum required capital in order to achieve greater consistency with the Basel standards,” Roper explained.

In documents secured by the Business Observer, the IMF said that large holdings of governement securities by Jamaican financial isntitutions make them vulnerable to a weakening in the fiscal situation while noting that “the design of the retail repo product, the basis of the secuirities dealer business model, is akin to a deposit — the customer makes a short term investment with a guaranteed return and does not directly take on the risk of the associated GOJ instrument, which remains with the dealer”.

The multilateral had estimated that as many as 20 per cent of dealers could “become undercapitalised and a few insolvent in some scenarios”.

The capital base of the domestic financial sytem represented 10.4 per cent of the total assets held by the local firms at the end of December 2009, improving from year-earlier levels of 9.6 per cent. The capital adequacy ratio(CAR) also improved from 15.4 per cent at end December 2008 to 18.9 per cent at end December 2009. That CAR had tested qualifying capital in relation to Risk Weighted Assets and Foreign Exchange Exposure.