Assessing the Impact of Financial Instability: The Jamaican Case Study
Tennant, David, Kirton, Claremont, Ibero-americana
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The disastrous effects of recent financial sector crises in South East Asia and Latin America have generated lengthy debates on the causes and appropriate responses to such crises. The almost exclusive focus on these issues has, however, led to a dearth of systematic and thorough studies of the impact of financial instability and crises on financial sector intermediation, and on the finance-growth relationship. It is now widely accepted that financial institutions can facilitate economic growth by mobilizing savings, allocating these savings to the most productive investments, and by enhancing the smooth flow of trade required in any market-driven economy (Levine 1997: 692-701). However, the sector's ability to effectively and efficiently perform these functions is heavily dependent upon the stability of the financial system. The theoretical literature strongly suggests that financial instability can undermine the intermediation process by reducing funds available for investment (Bernanke 1983: 257 and Stiglitz, 1993: 26), by causing inefficient allocation of investments (Williamson & Mahar 1998), and by precipitating a crippling of the payment system with the onset of financial panic (Diamond & Dybvig 1983: 403).1
This paper seeks to estimate the extent to which these theorized impacts of financial instability impeded the ability of Jamaican financial institutions to facilitate economic growth. Conclusions are made regarding the major channels through which financial instability affects the real sector, and the types of institutions that are most harshly affected by financial instability, and therefore necessitate closer scrutiny by financial regulators and supervisors.
The paper will proceed as follows: section 2 introduces the Jamaican case study by describing the financial sector crisis that occurred in mid to late 1990s; section 3 highlights the methodology, data and control group countries used in this study; section 4 estimates the effect of financial instability on financial sector intermediation in Jamaica, by examining the impact of instability on three major channels through which the sector facilitates economic growth and on the operational efficiency of the financial institutions; and section 5 summarizes and concludes the study.
II. THE JAMAICAN FINANCIAL SECTOR CRISIS
The major cause of the Jamaican financial crisis was an unduly-hasty liberalization of the financial sector, without prior improvement to the regulatory and supervisory framework (Kirkpatrick & Tennant 2002: 1935-1936). The Jamaican government liberalized the financial sector between 1986 and 1991, as part of World Bank Structural Adjustment and IMF Stabilization Programmes. This involved, inter alia, removing the ceilings placed on banking system credit, the total deregulation of savings rates, and dismantling exchange controls.
Following liberalization, the Jamaican financial sector experienced rapid expansion and deepening in early to mid 1990s. The operations of commercial banks and nonbank financial intermediaries (NBFIs) increased significantly, and new large financial conglomerates emerged (Stennett, Batchelor & Foga 1998: 12). These conglomerates ventured aggressively into more innovative financial activities and into acquisitions and operations of many real sector projects. There was also rapid expansion of lending to the private sector, but it is argued that this expansion was unsustainable, as risks were not properly assessed, collateral was inadequate, and loans were allocated mainly for consumer-oriented activities (Green 1999: 4).
It is therefore not surprising that private sector credit, which grew by almost 70% in 1993, slowed significantly to 25% in 1996, and non-performing loans as a percentage of total loans by commercial banks grew from 7.4% in 1994 to 28.9% in 1997. …