Ewart S Williams: Implications of the current financial crisis for Trinidad
and Tobago
Address by Mr Ewart S Williams, Governor of the Central Bank of Trinidad and Tobago, at a
TTMA Seminar "Crisis in global financial markets: implications for Trinidad and Tobago",
Port-of-Spain, 26 September 2008.
* * *
Thanks for the invitation. The sub-prime crisis first grabbed the headlines sometime around
August 2007. Who would have thought that after one year of high-priced casualties, not only
is the end not in sight, the ongoing spillovers now threaten to destroy the workings of the
international financial system as we know it. We are now seeing, among the industrialized
countries a level of financial panic the likes of which we have not seen in our life time.
President Bush, in making the case for the US$700 billion rescue package warned that "the
entire US economy was now in danger": he cautioned that the current crisis could wipe out
banks, empty retirement nest-eggs, send home-values into a free-fall and create millions of
new jobless. Warren Buffet called the crisis "a financial Pearl Harbor".
The speakers before me have given their take on how the crisis will affect various sectors of
our economy. I will try to avoid too much overlap by focusing on the impact of the crisis on
the country's external reserves and on our financial system as a whole. In the latter
context, I would also like to suggest some lessons for financial sector regulation. I would end
with a few brief comments on the macro-economic risks to the economy as a whole.
Last week, at least two commentators wondered why specific details on the impact of crisis
on the country's reserves were not forthcoming, surmising that the Government or the
Central Bank had something to hide. With the indulgence of my host, I would like to address
this issue in some detail.
Let me say up front that, as far as the official reserves are concerned, we have not suffered
any capital losses as a result of the financial turmoil on Wall Street. And this is so because
we have stuck to our mandate which requires the Central Bank to adhere to conservative
reserve management principles and to have in place as many risk mitigants as feasible.
Let me explain our reserve management system:
Very often central banks are criticized for being too conservative in investing the country's
reserves and not maximizing their income potential. It's an unfortunate criticism since the
conventional wisdom is that generating returns is not the primary purpose for holding central
bank reserves. For all central banks, capital value preservation is paramount. Simply put,
reserves should be invested at low risk.
Of course, reserves represent the country's savings and thus the return objective should not
be entirely neglected. Typically for central banks, the return objective is secondary to liquidity
and safety.
And this has been our approach to managing the country's reserves.
As you know, official reserves have increased significantly since 2000, in line with the
increase in international energy prices. Currently, official reserves stand at US$ 8.5 billion
compared with US$1.4 billion at the beginning of the decade. This represents a six-fold
increase.
To handle our increasing wealth, a few years ago the Bank introduced a structured foreign
reserve management strategy, allocating these resources between three tranches; one to
meet working capital needs; another tranche, as a second line reserve; with the residual
allocated to an investment tranche.
The Bank engages six foreign money managers (including the World Bank) to manage
portions of the reserves according to international benchmarks. External managers handle
32 percent of our total official reserves, while 68% is managed by the Central Bank. Lehman
Brothers was one of the external managers.
Consistent with international best practice the Bank utilizes an independent custodian to
safe-keep the foreign assets. This custodian arrangement ensures that our assets are not
co-mingled with the resources of the external manager. This proved to be extremely
important since it meant that in the case of Lehman Bros our resources were not involved in
Lehman's insolvency.
Our strategy also provides for investment guidelines designed to reduce the risk to which the
portfolio is exposed.
•
One such guideline specifies a minimum rating for the banks in which the deposits
are lodged.
•
A second guideline puts a ceiling on the amounts that can be deposited into each
bank.
As at the end of August 2008, just before the latest episodes of global financial stress
•
some 58 per cent of central bank reserves was invested in money market
instruments;
•
26 per cent was invested in US government and other GF government bonds;
• 6 per cent was invested in agency bonds (Fannie Mae and Freddie Mac); and
•
the remainder was held in asset-back securities and other money market
instruments.
This structure helped in insulating the official reserves from any loss.
All our deposits are in commercial banks which have not been affected by the recent crisis.
You would note that, so far, the turmoil has been largely in the investment banks: Bear
Stearns, Lehman Bros, and Merrill Lynch; with some ripples in Goldman Sachs and Morgan
Stanley.
Our US bond holdings have benefitted from the increase in prices consequent on the flight to
quality, which has been the main reaction to the market meltdown.
Our limited exposure to Fannie Mae and Freddie Mac bonds (some 6 per cent of our total
reserves) could have resulted in some losses. However, the US Government take-over of
these institutions has reduced, if not eliminated, the risk of this exposure.
Lehman Bros, as one of our external managers managed about 6 per cent of the total
portfolio. The bulk of these resources was invested in treasury securities of G7 countries,
and as such faced very low risk. A very small amount (US$85 million) was invested in a
mutual fund sponsored directly by Lehman Bros. We were able to liquidate this asset at no
loss.
The bulk of our asset-backed securities were issued by Merrill Lynch. The take-over of this
institution by the Bank of America eliminates or reduces the risk attached to this asset.
But ladies and gentlemen, if we had any doubts, the current turmoil in international financial
markets should remind us that no institution is totally immune from possible contagion,
regardless of what the rating agencies may say.
As you may know, not too long before Bear Stearns was declared insolvent it was rated BBB;
Lehman Bros was rated (A+) and Merrill Lynch (A+): they were all considered investment
grade. Before selecting Lehman Bros as an external manager, we went through a rigorous
selection process that not only included examination of past performance of funds managed
and Lehman's ability to deliver superior returns, we also conducted a thorough examination
of Lehman's financials.
But as happened many years ago, with the dot-com crash, investor sentiment can change
very quickly and sharp declines in stock prices can quickly erode the capital of even the
strongest banks, producing the dire consequences that have attended three of the world's
five largest investment banks.
Since Lehman's and Merrill Lynch's difficulties, the Bank has carefully reexamined the
financial status of all our counterparties as well as our investment managers to ensure that
none of these are on any watch-list. We have also taken the decision to introduce two new
elements to our investment strategy. First, until financial markets have been stabilized,
maturing deposits will be rolled over but for shorter periods and second, we will aim for
further diversification among banks (within our approved guidelines), even at the risk of lower
returns.
I would just make this brief comment on the HSF. As you know, the plan is to invest HSF
with a focus on returns, subject to an acceptable level of risk.
resources more aggressively
A few months ago the HSF Board approved a Strategic Asset Allocation which called for
HSF funds to be invested in money market instruments, US government bonds of a maturity
of 1-5 years, and US, and global equities. Under the HSF Act, the Central Bank is to act as
the Fund Manager with the understanding that the management of the equity portfolio will be
outsourced.
Over the past few months, the Bank has been involved in the selection process for the
external managers. The HSF Board agreed that pending the selection of the external
managers and the implementation of the Strategic Asset Allocation, the HSF resources
should be invested like the central bank reserves.
Consistent with this guideline the resources are invested in short term deposits (95 per cent)
and US treasuries (5 per cent). The deposit holdings are subject to the same prudential
guidelines. Consequently, these reserves have suffered no loss and are at no undue risk.
Impact on the financial system
Having surveyed most of our domestic financial institutions we can say, with a great deal of
certainty, that the immediate impact of the crisis has been minimal. Some institutions had
direct exposure to Lehman Bros, Merrill Lynch and AIG but in all instances the exposure was
minimal, in relation to total assets.
From our analysis there is no immediate risk facing our banking system which happens to be
well capitalized (with a capital/assets ratio of about 18 per cent), with a very low level of
nonperforming loans and basking in excess liquidity.
Unlike the banks in large emerging markets the lending operations of our banks are based
on local deposits rather than on borrowing from foreign banks. All of our local banks have
foreign short-term revolving credit lines. However, given the ample availability of foreign
exchange from the central bank and in the domestic market, these lines are quickly
amortized when used. The credit crunch is unlikely to affect the availability of these lines
though there could be some increase in cost.
The insurance companies in Trinidad and Tobago also, for the most part, match their
domestic liabilities with an investment portfolio heavily concentrated in domestic assets.
Some companies have external exposure but to a very limited extent.
But ladies and gentlemen, if the Wall Street crisis should remind us of anything, it is that we
can't be complacent. Rather, the crisis should spur all our institutions to take a close look
at their risk management systems and it should make us realize that it is in all our interest
to have robust regulatory systems.
We are hoping to have a new FIA in place before the end of the year and we expect to have
a new Insurance Act and perhaps new Credit Union legislation by the middle of next
year. While this is progress, ladies and gentlemen, there is a view that even the proposed
new legislation will not be as robust as it should be and still short of international best
practice.
I can't help making the observation that because we have not had a systemic disruption in
our financial system for several years, many of our institutions prefer to cling to the
status-quo and fight change even when they recognize the risks involved in not
upgrading the existing systems.
How else could one explain:
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The tendency for so many institutions not to have audited accounts, six months after
the end of their fiscal year;
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The opposition to the separation of an institution's financial and non-financial
activities to avoid contagion; or
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The reluctance on the part of some institutions to readily support steps to reduce
related party transactions, or strengthen internal audit, or corporate governance
practices.
In the Bank's view, the current turmoil in the US market should serve as a catalyst for boards
of directors and senior management of all companies, whether they are banks, insurers or
credit unions, to look closely at their risk profile and determine if their level of capital and
liquidity are appropriate to their individual circumstances. Also these tough times, having
unbiased and objective advice and thinking is crucial and the existence of independent
directors on companies' boards would facilitate this.
Unfortunately, not all companies see these requirements as being essential to mitigating
unnecessary risks.
And finally, ladies and gentlemen, in terms of the macro-economics, what can we expect
going forward?
I really wish we had a crystal ball to predict how the global economy will evolve in the short
term. Unfortunately, we don't and in such a situation, prudence is the best policy; a policy of
preparing for the worst and putting systems in place to meet any downside. In a way, that's
what risk management is all about.
And what are the downside risks?
Well, even if order is quickly restored to the US financial system, with the approval of the
$700 billion package, the consensus is that the global economy is scheduled to undergo a
pronounced slowdown (some are using the R word...recession).
If this occurs, the reduction could prompt a fall in international oil and energy prices. Under
these circumstances, something will have to give; either a reduction in expenditure or a
reduction in savings through the HSF, which strictly speaking, is permitted under the HSF
Act. Either option has unpalatable consequences.
Trinidad and Tobago is in a better position to withstand a global slowdown than our
CARICOM neighbors, who have already begun to experience declines in tourist arrivals and
in migrants' remittances. If this goes beyond a certain level, our manufacturing sector which
contributes US$1 billion in exports, but provides substantial employment, could be affected.
These are just two examples.
There is no doubt that compared to the 1980s, we are in a better position now to withstand a
global down-turn. But borrowing from the current lexicon, we have by no means de-coupled
and a global slowdown could present a new set of challenges and at least slow our advance
to our 20/20 vision.
But ladies and gentlemen, "God is a Trini" and these risks may not materialize. Even if we
are inclined to take this view, we should see in the current global financial crisis, an
opportunity to further strengthen our economic fundamentals most notable by reducing
inflation, increasing productivity and accelerating the diversification of our non-energy sector.
That is the surest way of ensuring self-sustaining growth and improvements in the quality of
life for our population.