THE financial sector appears to have bested the first year of the domestic debt swap — Jamaica Debt Exchange (JDX) — which saw the Government exchange high cost debt for lower interest notes, with most posting higher interest margins last year than the year before.

Some financial sector players, however, now believe that banks may have to get through 2011 to say that they have weathered the worst.

Only two of the nine financial insititutions listed on the Jamaica Stock Exchange (JSE) saw declines in net interest income last year — Scotia Group and Scotia DBG Investments.

What’s more, the nine banks collectively saw net interest income for 2010 increase over year-earlier levels, albeit, marginally.

But PanCaribbean Financial Services’ (PCFS’) CEO, Donovan Perkins believes that certain market segments remain vulnerable to the effects of inflation. “Unchecked inflation remains a significant risk to the current benefits derived from JDX,” he said. “That’s where policymakers need to focus some of their attention, ensuring that inflation remains in check, and get the economy growing.”

The inflation rate for 2010 came in at 11.7 per cent and central bank projections for 2011 is within the range of 7.5 to 9.5 per cent.

However, Bank of Jamaica 180 day T-Bill, a reference point for the risk-free rate, or the interest rate at which investors can seek returns on their funds without observing any risk, is priced at 6.75 per cent.

In the absence of higher returns in the inflationary environment, better growth is necessary.

Perkins argued that lower rates post JDX have not translated into the GDP growth or positive reaction from the equities market that could further reduce the risk for investors and financial institutions.

“Japan is a classic example of an economy with very low rates and weak growth. It is necessary but not sufficient,” Perkins remarked. “The problem is that while the BOJ can manage M1/M2 (money supply) it has limited capacity to keep imported inflation such as the movement in oil, commodities, etc in check. Sustained inflation impulses from external sources could make the BOJ’s job much more challenging in these circumstances.”

The JDX was widely regarded as a ‘game changer’ for financial institutions in Jamaica in 2010. The reductions in interest rates that was necessary following the conclusion of the Exchange on February 28, 2010 have resulted in some institutions recording reduced profitability for the year as interest spreads, and the returns on net interest income, narrowed.

“I think smaller institutions will have it tougher than they have in the past in this environment,” Perkins said. “The ‘high interest rate’ subsidy has diminished, and businesses are going to have to identify sweet spots where they can develop expertise and serve profitable segments,” he said of the post-JDX environment in 2011.

At the same time, even with rates at an all time low, others think the reduction in interest rates are not yet fully reflected in the market, a fact that could further reduce interest income over the years.

Loan rates still hover between 10 per cent and 17 per cent within the sector and as Finance Minister Audley Shaw seeks to make good on his promise to take banks “kicking and screaming” into single-digit interest rates this year, the effect of an even lower interest rate environment could reverberate throughout the financial sector.

According to one financial sector boss, the change in interest rates, for example, those on long-term loans, such as mortgages and car loans, have not yet fully passed through the system. Institutions are still earning high rates on those loans now, but when those rates are repriced at the conclusion of the loan period, that is when the full effect will be seen.

Sushil Jain, financial analyst, said this could take years.

According to Jain, this is because the interest rates on loans will not go down further in any significant way in the short term.

“The rates on the residential mortgages have not gone down even by one per cent,” Jain said. “The institutions are in an advantageous position and they have to have a spread for bearing the risks.”

Even with a spread, some financial institutions were not spared from the effect of the JDX in 2010. Traditionally strong performers such as Scotiabank, with total assets of $326 billion in 2010, recorded profits of $10.4 billion in 2010, down from the $11.1 billion in 2009.

In his address to shareholders at the Annual General Meeting last week, Scotiabank CEO Bruce Bowen said the “biggest impact on earnings last year was as a result of the JDX”.

“In February 2010 we exchanged a total of $91 billion of GOJ securities yielding average rates of 17 per cent for new securities with average yields up to 600 (six per cent) basis points lower,” Bowen declared. “We also saw significant declines in benchmark interest rates. For example, T-Bill rates, a reference rate against which the largest corporate and public sector customers borrow, fell by almost 1,000 (10 per cent) basis points from 17.04 per cent at the start of the fiscal year to 7.92 per cent at the end of the year. This, of course, had a significant impact on our interest revenues.”

Jain, said all institutions will have to adapt and respond to the changing economic landscape post JDX.

“Managements have to take necessary actions to respond to the change by cost cutting, developing new products and better service standards,” he said. It is a point supported by Perkins, who argued that the risk to these institutions post JDX should be moderated if the Bank of Jamaica (BOJ) allows the market to diversify investment holdings outside just GOJ bonds.

He said collective investments schemes, if they gain more acceptance locally, should help investors, and institutions diversify the risks associated with the low interest rate environment that will become a feature of 2011. According to Perkins, collective schemes, such as unit trusts and mutual funds, have been slow in developing to cover this shortfall, in part related to regulatory impediments and market acceptance.

Perkins’ argument for a more diversified portfolio this year is supported by a modest growth over 2009 levels for PCFS.

By the end of the financial year 2010, PCFS generated after-tax profits of $1.5 billion, an increase of three per cent over 2009, and despite a lower interest rate environment saw net interest margins at PCFS uptick from $2.62 billion to $2.75 billion. PCFS said the improvement to net interest income over year-earlier levels was influenced mainly by balance sheet growth.

Similarly, Sagicor Life Jamaica increased its profits six per cent over 2009 for the financial year 2010, to $4.67 billion. According to the CEO Richard Byles, the fourth quarter of 2010, was stronger than the 2009 fourth quarter, in part, due to an increase in the actuarial liabilities in December 2009 in anticipation of the JDX.

Byles, in a statement to shareholders noted that Sagicor also made an effort to invest in longer term securities to protect itself from the falling interest rate environment.

“Interest rates in single digits while tough for retirees, will be good for the economy in the medium term, if inflation is managed and held in check,” said Perkins. “If investors begin to see a course for sustained growth, Jamaica will be a great market to be in. It’s a matter of confidence and right now, while it is clearing, there’s still smoke in the room.”