In the aftermath of the the novel coronavirus pandemic, many global issues have emerged. Some, like supply chain disruptions, have been a direct consequence of the drastic slowdown in economic activity due to the pandemic. Others, however, like increased oil prices, have been a consequence of the Russia/ Ukraine war and other global geopolitical occurrences. These have combined to increase economic uncertainty globally, heighten inflation, increase interest rates, and slow global growth.

The World Bank has reduced its 2022 global growth forecast from 4.1 per cent (January 2022) to 2.9 per cent (June 2022). While this is problematic by itself, what has been even more concerning is the fact that the current severity of inflation, and the accompanying risks, has far exceeded what was initially expected by central banks globally. Indeed, inflation has become far more entrenched and broad-based, affecting most goods and services with a level of severity that has not been witnessed in more than 40 years across the US and other developed nations.

In response, global central banks have become far more aggressive in their fight against higher prices by significantly increasing interest rates. As a marker of how severe inflation has become, the US’s Federal Reserve (The Fed), which is considered the leading central bank globally, made it clear on May 4, 2022, that a 0.75 per cent increase in interest rates was not being “actively considered”. This implied that the maximum rate increase would be 0.50 per cent, in line with its 0.50 per cent increase enacted on May 4, 2022. However, by June 15, 2022, the Fed, against its own expectation and communication just over one month prior, raised interest rates by 0.75 per cent as inflation stubbornly moved ahead of its forecast. Notwithstanding the efforts to date, inflation remains heightened and the risk of a US recession — and therefore a global recession — has more than doubled from 15 per cent at the beginning of the year to 33 per cent based on consensus estimates.

Market reaction and consequences

Given the significant uncertainty in global asset markets investors have been diversifying away from risky assets, like stocks and bonds, and are aiming to hold as much cash or near-cash assets as possible to reduce their risk exposure. Further, as a consequence of the rapid sale of stocks and bonds, both developed and developing nations have witnessed asset price declines that mirror the most serious periods of economic distress in recent times, including the Global Financial Crisis of 2008/2009 and the worst period of the COVID-19 pandemic for financial markets — March 2020.

This has certainly had negative implications for government/sovereign bonds throughout the Caribbean, including Jamaica’s own sovereign bonds. To effectively communicate the devastating effects of the present environment we can simply visit the price of Jamaica’s US-dollar government bond that matures in 2045, which illustrates the most severely impacted Government of Jamaica (GOJ) global bond by the current spate of asset price deflation. At its highest point in 2021 the bond had a price of $144.78 in the international bond market. As of June 17, 2022, that same bond fell to a low point of $99.36, representing a decline of 31.4 per cent.

In line with this, the yield shock to financial institutions from these bonds has been equally significant, at 3.172 per cent. This yield increase represents an immediate risk to the possible deterioration of the capital of financial institutions. Additionally, three-month and six-month treasury bills have trended up over the same period by 7.03 per cent and 7.15 per cent, respectively, which means the cost of borrowing has increased more rapidly than the yields on longer-term assets. Consequently, highly leveraged financial institutions, with relatively low permanent capital and low capital adequacy that tend to borrow short term to invest longer term, are especially exposed in this period. This is in addition to the fact that the bonds are now worth far less since prices have plummeted.

For further context, the last time this bond’s price dipped this low was March 23, 2020, when it fell by 32.1 per cent from its highest point in 2020 prior to the start of the pandemic. The 2020 decline was a result of significant pandemic fears and the fact that a full-blown recession was underway — one that crippled financial markets in most countries. This means that, currently, without being in a recession, Jamaica’s sovereign bonds are trading at a level that suggests we are in a recession. This places immense stress on the financial services industry as companies within the industry own large quantities of sovereign bonds as these bonds are deemed as critical, safe assets and are therefore heavily held by industry participants.

These firms are facing several risks including:

1) Repricing risk: The cost of borrowing (interest rates) has increased significantly, particularly for short-term funding, while most assets over the last several years have been priced at fixed interest rates. As such, the net interest being earned by several financial institutions is contracting.

2) Liquidity risk: The decline in the price of these government bonds requires additional cash to buy more bonds to ensure the value of bonds used as collateral for borrowed funds remains at or above a minimum level. Essentially, financial institutions have to buy more bonds with the cash they have because they have to — not necessarily because they want to.

3) Exchange rate risk: The purchase of additional government bonds in US dollars means that Jamaican dollars may need to be used to purchase US dollars to buy these bonds. Given the urgency of the transactions, the exchange rate to quickly execute the purchase of US dollars might be unfavourable.

4) Capital adequacy risk: The decline in the bond prices creates losses that reduce the capital of these companies.

With those considerations, the principal concern being assessed by regulators is contagion risk, which could have a domino effect on several financial institutions. This is very reminiscent of the 2007/2008 global financial crisis, in that a single problem led to knock-on effects that affected the most vulnerable financial institutions. Moreover, a key point here is that we are not officially in a recession. This means that while the current issues being faced are mammoth, a recession would likely intensify the severity of the problems highlighted.

Role of prudent capital management

This backdrop of heightened uncertainty and the accompanying consequences clearly demonstrate why prudent capital management is paramount to business survival and continuance. Within that vein the capital adequacy ratio is a superior measure that is used to compare a regulated financial institution’s store of capital to its total risk-weighted (risk-adjusted) assets.

The greater the capital, relative to the institution’s risk-weighted assets, the greater the institution’s capacity to withstand significant shocks that negatively affect the return or price of the asset. In the case of bonds, the asset’s return and/or price can be negatively affected by a decline in the credit quality of the bond issuer or as a result of heightened market risks, such as the current environment marked by heightened interest rates, inflation, and geopolitical tension.

In some cases, the price decline of the bonds can be so significant that large losses are reported by financial institutions. As is customary for all companies, capital can be reduced by losses and increased by profits. Therefore, significant losses from assets, like bonds, can be “absorbed” by the capital of financial institutions and, as indicated, the losses reduce capital.

Given this dynamic, the greater the capital, the greater the loss-absorption capacity, and the higher the probability that the institution will remain solvent. As such, the financial institutions best positioned to handle crises such as the rapid selling of Jamaican government bonds have significant capital relative to assets (adjusted for risk); hence, the importance of the capital-adequacy ratio.

In that regard, the Bank of Jamaica provides relevant data that shows how the industry is positioned. As of March 31, 2022 the banking industry had a capital-adequacy ratio of 14.0 per cent, which is just above the regulatory minimum of 10.0 per cent, and down from the previous quarter’s 14.2 per cent. While a breakdown of the capital-adequacy ratio is not provided by the Bank of Jamaica, a generally accepted substitute is the capital to total assets ratio.

See Table 1 for data for each local bank

Interestingly, among industry participants, one company stood out quite significantly, Cornerstone Trust and Merchant Bank (CTMB), with a capital to total assets ratio of 45.7 per cent, which towered above the industry as exhibited in the Table 1. The next most heavily capitalised banks were Citibank and Scotiabank. Given the capital/total assets ratios, we can infer that the capital buffers above regulatory limits across the sector were not remarkable, with the noticeable exception of Cornerstone Bank. One can imagine, however, that these banks are generally maintaining capital reserves at their holding company level, particularly Citibank and Scotiabank, which can be released to support the licensee should circumstances warrant same.

A similar look at the securities dealer industry as of December 31, 2021 (most recent Financial Services Commission data at the time of writing), also shows that, coming into the year, the industry was adequately positioned with a capital-adequacy ratio of 25.3 per cent relative to the regulatory minimum of 10.0 per cent. Among the most robustly capitalised were Barita Investments Limited with an industry-topping capital adequacy of 52.7 per cent, followed by Scotia Investments Jamaica Limited with a capital adequacy ratio of 49.3 per cent, and Mayberry Investments Limited (23.4 per cent). Of note, Cornerstone Bank and Barita — who are top performers with respect to banks and securities dealers, respectively — are sister companies owned and managed by the Cornerstone Group. It seems hardly a coincidence that these sister companies have the strongest capital-adequacy ratios within the banking and securities dealer industry, suggesting that the Cornerstone Group, in a similar manner to banks and securities dealers in developed markets in the aftermath of the 2008 subprime crisis, has significantly bolstered the capital base of its operating entities.

The foregoing capitalisation thrust by international banks and brokers was undertaken within the context of stricter capital standards and stress testing by their regulatory authorities. Whether through luck, prudent foresight related to lessons learnt from the 2008 crisis, genius leadership, or a combination of the foregoing, the strong capital base of the Cornerstone operating entities serves all stakeholders well, especially under challenging market conditions.

Given the current market stress marked by ongoing pandemic-linked supply chain disruptions, the war in Ukraine, the rise in global and local interest rates, rampant inflation, and fears of an impending global recession, the capital adequacy of financial services companies needs close examination. This applies to both banks and securities dealers.

Put plainly, some industry participants are ill-prepared to handle the current environment without help from their parent companies or the central bank, particularly those companies with capital adequacy ratios that are just marginally above the regulatory minimum. To determine the true loss-absorbing capacity of some financial institutions a stress test was performed which looked at the capital adequacy ratios of securities dealers if there were a simultaneous 6 per cent yield increase in domestic and international interest rates. The results indicate that Scotia Investments and Barita Investments are among the only securities dealers that could withstand such a shock. Within the context of the foregoing, the market looks forward to seeing the results of the latest stress test carried out by the Bank of Jamaica on the financial sector, the output in relation to which should have been made available at the end of June 2022.

The prudent positioning of some members of the securities dealing sector, led by Scotia Investments and Barita Investments, has ensured the robust loss-absorbing capacity of these institutions which is supportive of an overall stronger financial sector. Therefore, as the financial services industry at large looks ahead with the aim of navigating this difficult environment marked by the heightened risk of a recession, it is the institutions with the strongest capital buffers that are best positioned to withstand current and expected shocks.

Andre Haughton, PhD, is senior lecturer in international finance in the Department of Economics at The University of the West Indies and an IMF Distinguished Fellow.