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CHAPTER 2: Financial Integration in the Caribbean

Author(s):
Sanjaya Panth, Paul Cashin, and W. Bauer
Published Date:
October 2008
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Author(s)
Goohoon Kwon, Sanjaya Panth, Jingqing Chai, Alejandro Guerson, Greta Mitchell Casselle and Rafael Espinoza 

A. Introduction 1

Integrating national capital markets is an explicit objective of the Caribbean Community (CARICOM), as part of its drive to create a common economic space. The revised treaty of Chaguaramas, establishing the Caribbean Single Market and Economy (CSME), stipulates the removal of restrictions on the provision of banking, insurance and financial services as well as on the movement of capital across national boundaries.2 The single-market component of the CSME has a target date of 2008 for its full establishment, while the single economy is expected to be phased in gradually over a longer horizon.

Financial integration among Caribbean nations can confer numerous benefits.3 It can increase the availability of capital, especially to small firms and countries; reduce the cost of capital all around; and spur improved financial standards and regulations. All of this, in turn, leads to higher economic growth and improved living standards—the ultimate objectives of integration.

Financial integration is, however, not a panacea and it also poses important risks and challenges. The benefits of integration are not likely to be equally shared across all countries or institutions. As regards risks, integrated financial markets allow shocks (including sudden stops or reversals in capital flows) to spread across borders much more rapidly. At the same time, there is also the danger that an excessive focus on the regional dimension of integration can lead to increased inward-orientation—so that even as integration within the grouping increases, it falls relative to the rest of the world with a loss of the attendant benefits. Finally, integration poses a special set of challenges to national regulators who lose full control over their own financial markets precisely when the assessment and management of risks becomes more complex.

This chapter reviews the process of financial integration in the Caribbean and assesses its policy implications. It does so by reviewing the state of Caribbean financial markets and offering suggestions on issues to watch out for, or steps to take, to ensure that integration occurs in a manner that maximizes its benefits while reducing risks. The rest of the chapter is organized as follows: Section B provides an overview of the region’s financial sector; Section C develops the overall case for integration; and Section D assesses the current state of financial integration in the Caribbean. The following two sections focus on policies, with Section E addressing issues that are impeding integration and Section F, the regulatory reforms necessary to support integration. Section G concludes.

B. The Regional Financial Sector in Perspective

Financial linkages often follow trade and the latter is relatively low among Caribbean countries (Table 2.1). Intraregional trade in goods has increased among CARICOM members in recent years but still accounts for only about one-tenth of regional GDP. This is broadly comparable to two other regional groupings selected for comparison purposes in this chapter: MERCUSOR+5 (southern American countries) and ECOWAS (the West African economic community). Regional trade in the Caribbean remains, however, far below levels in the other two regional groupings considered here, the EU-15 (pre-2004 boundaries of the European Union) and ASEAN+3 (Chiang Mai initiative countries). The relatively low level of intraregional trade in the Caribbean reflects, in part, the large role played by the United States as a bilateral economic partner for the countries in the region—the United States accounts for about 40 percent of the total external goods trade of Caribbean countries as well as the bulk of their trade in services.

Table 2.1.Regional Economic Blocs: Selected Indicators, 2004
Population (millions)GDP (US$ bn)Income per Capita (’000 US$)Intraregional TradeNumber of States
WeightedUnweighted
(In percent of GDP)
CARICOM15402,6769.515.714+1
ECOWAS 12541315147.110.415
MERCOSUR+5 23691,1853,2137.615.65+5
EU1538412,31132,09533.157.415
ASEAN+3 32,0317,9913,93418.443.010+3
Sources: IMF World Economic Outlook Database.

Economic Community of West African States.

Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Paraguay, Peru, Uruguay, and Venezuela, Rep. Bol.

ASEAN countries plus China, Japan, and Korea (Chiang Mai Initiative countries).

Sources: IMF World Economic Outlook Database.

Economic Community of West African States.

Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Paraguay, Peru, Uruguay, and Venezuela, Rep. Bol.

ASEAN countries plus China, Japan, and Korea (Chiang Mai Initiative countries).

Caribbean financial sectors are, however, large relative to the size of the regional economy and are important contributors to regional output (Table 2.2). Bank assets, excluding those of off-shore banks, are close to regional GDP. Nonbanks are even larger than banks in Jamaica and in Trinidad and Tobago, which together account for about 65 percent of the region’s financial sector. All in all, total regional financial sector assets exceed 150 percent of regional GDP.4 Reflecting its large size, the regional financial sector accounts for about 8 percent of annual regional output, which is above the G-7 average of 7 percent. In terms of individual countries, Trinidad and Tobago’s financial sector contributes to the production of one tenth of its GDP—a share comparable to that of Singapore, a major financial hub.

Table 2.2.Assets of Financial Institutions: Selected CARICOM Countries
T&T 2003Jamaica 2004Barbados 2001ECCU 2004Bahamas 2003Guyana 2004Belize 2004Average & Sum
(In percent of GDP)(Average)
Total assets170185129195136153116167
Banks778710518311511497100
Nonbanks9498251220391967
(In billions of U.S. dollars)(Sum)
Total assets20.416.73.36.07.51.21.256.4
Banks9.27.82.75.76.30.91.033.6
Nonbanks11.28.90.60.41.10.30.222.8
Memorandum item:
GDP12.08.72.63.15.50.81.033.8
Sources: Authorities; and Fund staff estimates.
Sources: Authorities; and Fund staff estimates.

A key feature of Caribbean financial sectors is their dominance by large and long-established financial conglomerates (Table 2.3). Firms within individual conglomerates include commercial banks, merchant banks, building societies, security dealers, and sometimes also insurance companies. Most conglomerates are limited to holdings in the financial sector but in one or two cases have sizable assets in other sectors as well. The combined assets of the nine largest financial conglomerates (some of which also have mutual linkages in terms of cross-holdings) are almost the size of regional GDP. Most of the conglomerates were established before independence, which occurred in the 1960s for many of the CARICOM countries. All of the conglomerates operate simultaneously in several Caribbean countries, possess extensive networks of branches and affiliates, and, with one exception, are based entirely or mostly within the region.

Table 2.3.Large Financial Groups in the Caribbean, 2004
Name of the InstitutionsDomicile CountryAssets (US$ bn)Market Capitalization (US$ bn)Founded in
First Caribbean International BankBarbados$10.0$3.31836/1920
Royal Bank TT Financial HoldingsT&T$6.2$2.81856
Republic BankT&T$5.0$2.11837
Guardian Holdings LimitedT&T$2.8$1.41847
Bank of Nova Scotia, Limited 1Jamaica/T&T$4.1$1.41889
National Commercial BankJamaica$1.6$0.81837
Sagicor Financial CorporationBarbados$3.3$0.61840
Jamaica Money Market BrokersJamaica$1.0$0.41992
CL Financial Group 2T&T$4.31936 2
Total$38.3
Memorandum item:
GDP: CARICOM 15$39.5
Sources: Company publications and Fund staff estimates.

For subsidiaries of Scotia Bank of Canada in Jamaica and Trinidad and Tobago (T&T). Its other Caribbean subsidiaries and branches are not included here due to data limitations.

For Colonial Life Insurance Company (CLICO), a flagship company of the Colonial Life Group, including CMMB, CLICO and Clico Investment Bank.

Sources: Company publications and Fund staff estimates.

For subsidiaries of Scotia Bank of Canada in Jamaica and Trinidad and Tobago (T&T). Its other Caribbean subsidiaries and branches are not included here due to data limitations.

For Colonial Life Insurance Company (CLICO), a flagship company of the Colonial Life Group, including CMMB, CLICO and Clico Investment Bank.

The region’s complex financial sectors offer a diverse range of products (Box 2.1). While banks still remain the largest segment of the financial sector in many countries, nonbanking financial institutions have grown rapidly in the larger countries. In particular, securities dealers in Jamaica and mutual funds in Trinidad and Tobago now have funds under management exceeding banking system deposits. Pension and insurance companies are also large in Trinidad and Tobago and, to a lesser extent, in Jamaica, accounting for some 40 and 20 percent of total financial assets in each country, respectively.

Box 2.1.Innovative Products and Regulatory Challenges

Jamaica’s system of security dealers and Trinidad’s mutual fund industry exemplify how Caribbean nonbank financial institutions are often in the vanguard internationally in offering innovative financial products, but in so doing, they often create challenges for regulators.

Jamaica. The securities sector has flourished in recent years, taking advantage of the high yield on government paper. Prompted by a confluence of factors, including regulatory and temporary tax advantages, the sector has grown to play a large role in the financial system, with assets amounting to half of GDP. The impressive growth has largely come from the repo business—short-term borrowing from households through hold-in-custody repurchase arrangements (repos) to fund investment in long-term government paper. The net interest income generated from the difference between short- and long-term interest rates has been the main source of profits for dealers.

Sources: Bloomberg and Bank of Jamaica website.

1/ The yield for 6 months on 4/24/06 is proxied by 6-month TB yield issued around the same time.

Notwithstanding some recent flattening of the yield curve, the sector remains significantly exposed to interest rate and roll-over risk. A rise in long-term interest rates reduces the value of fixed rate assets and a sharp rise in short-term rates squeezes profitability, given the need to continuously roll over repo agreements with households. Legal ambiguities on the control rights over the underlying securities could also exacerbate risks.

Trinidad and Tobago. The mutual fund industry has grown rapidly in recent years, with funds under management surging from less than 10 percent of GDP in 2000 to nearly 40 percent of GDP in 2005. The rapid expansion is due mainly to attractive returns relative to bank deposits. All major financial institutions in the country, including banks, operate mutual funds. There are no restrictions on overseas investments.

Collective Investment Schemes: Funds under Management (in T&T$ millions)
200020012002200320042005 1
Total funds under management4,7599,39015,42421,43827,09234,244
Money market fund2,4516,37611,34315,22718,28323,109
Growth and income fund1,2991,4502,0093,5025,2196,597
Bond fund9531,5051,9642,4392,8883,650
Equity fund423753190563712
Pension/annuity scheme15235682120152
Hybrid fund00001924
Memorandum item:
Deposits2179482082221522211812587229961
Total funds in percent of GDP9.317.127.431.935.237.9
Source: Trinidad and Tobago Securities and Exchange Commission (2005).

Estimates.

Deposits in the consolidated financial system.

Source: Trinidad and Tobago Securities and Exchange Commission (2005).

Estimates.

Deposits in the consolidated financial system.

The authorities are moving to strengthen regulation. A major loophole identified by the Trinidad securities commission is that mutual funds are not required to disclose their holdings, nor to report to the authorities as they operate under trust arrangements. The authorities have already drafted amendments to address the problem, but its passage remains pending. Given the lack of reporting/disclosure requirements, Trinidad and Tobago’s mutual funds are, therefore, currently de facto unregulated, similar to hedge funds or private investment clubs. Some are exposed to currency risk. Others, in particular money market funds, are exposed to liquidity risk, given that under their operating rules most funds are analogous to demand deposits (some even offer ATM cards). Although principal is meant to be protected under trust arrangements, remuneration rules in the case of losses are unclear and the public may be unaware of the inherent risks.

Notwithstanding the large and complex financial sectors, financial markets in the region are mostly underdeveloped and illiquid (Table 2.4). Bond markets are dominated by government securities, and secondary markets are almost non-existent, except in Jamaica. Even in Jamaica, the secondary bond markets are illiquid, due in part to an outdated settlement and custody system. As regards stock markets, there are six exchanges in CARICOM, with a combined market capitalization almost twice regional GDP. However, market turnover is extremely low. Similarly, while some financial derivatives, notably strips and structured products, are popular, they are issued over the counter and held to maturity, given the absence of secondary markets.

Table 2.4.Turnover Ratios of Selected Exchanges, 1997–2003(In percent)
UKUSANorwayArgentinaSingaporeT&TBarbadosJamaica
19973958865362016
19986244865761553
199966528620102322
20007951912061322
20017984631252303
20029911410012722283
2003719577364453
Average7171842568363
Source: Trinidad and Tobago Securities and Exchange Commission (2005).
Source: Trinidad and Tobago Securities and Exchange Commission (2005).

The complex, yet underdeveloped, financial markets pose challenges for policy makers. The extensive and sometimes opaque cross-holding structures of the conglomerates and rapid growth of novel products complicate the tasks of designing and enforcing prudential regulations. At the same time, the illiquid nature of the markets distorts or limits the usefulness of price signals. Illiquidity can also have macroeconomic repercussions—during periods of stress, for example, the illiquidity can cause prices to overshoot and also amplify financial institutions’ demand for resources from lenders of last resort. Finally, there is the challenge of fostering development of the financial sector in a fiscally prudent fashion. For example, many Caribbean countries have offered tax incentives to promote development of the financial sector but the efficacy of these efforts remains to be demonstrated.

C. The Benefits of Integration

The main benefit of financial integration is that by contributing to financial development, it can increase the rate of economic growth. The positive relation between financial development and economic growth has been extensively studied and documented in the economic literature.5 Furthermore, Edison and others (2002) find that financial integration is strongly correlated with growth performance across countries. Although, Edison and others find that integration loses its significance after including financial development as a separate explanatory variable for growth, financial integration remains correlated with financial development in their study. There are also strong reasons to believe that integration can lead to financial development (see below).

Financial integration contributes to financial development by improving access to financing and lowering its cost. Financial integration increases the availability of capital to the entire integrating region. First, financial flows within the region increase as both savers and investors in the less financially developed parts gain access to developed markets to intermediate their needs. Second, larger markets are more likely to attract capital from outside the region, further increasing the overall volume of available resources. Integration also reduces the cost of capital by exploiting economies of scale and leading financial intermediaries facing new competition to become more efficient. Finally, financial integration contributes to financial development by enabling the dissemination and adoption of best practices, whether by individual firms or by regulators.

Financial development, in turn, leads to growth by increasing investment and improving resource allocation. The volume of investment increases with the greater and cheaper availability of capital in deep and liquid financial markets. As regards improving resource allocation, developed financial markets better transmit price signals, which in turn enable creditors to better identify the relative risks and rewards of alternate investment opportunities. Financial development can also positively affect investment in other, less obvious ways—for example, by increasing the opportunities for diversification. Specifically, in an economy with low financial development, firms’ shares tend to be held by a small group of shareholders. As these shareholders’ risk remains undi-versified, they require a relatively high return from their assets, which in equilibrium results in a lower level of investment. Opening the set of opportunities to diversify can, therefore, be expected to result in higher overall demand for investment.6

The growth benefits of financial integration can be substantial. Based on the seminal work by Rajan and Zingales (1998), a European Union (EU) study concluded that if integration were to lead to all countries in the union to gain access to financial markets as developed as that of the United Kingdom, annual average GDP growth in the European Union would increase by about ¾ percentage point. In their study, the authors present estimates derived from a world-wide sample of industries and countries of the extent to which financial development helps contribute to the growth of various industries. Applying these estimates to the Caribbean suggests that annual growth in CARICOM could increase by about 0.6 percentage point per year if, as a result of integration, all regional countries had access to financial markets similar to those of Barbados (Box 2.2).7 The countries that would benefit the most are those that are currently less financially developed (Haiti and Suriname), but virtually all the countries would share in the benefits.

Box 2.2.Financial Integration and Growth: Estimating the Benefits

Rajan and Zingales (1998) identified how financial development causes growth and also provided a means for estimating the size of the benefits. Their model is based on the notion of financial dependence—that different industries have different levels of need for “external” financing (i.e., from outside of the firm’s own cash flow) because of differences in technologies. Also, the opportunities for external financing are greater and the costs lower in economies with a higher level of financial development. Intuitively, therefore, firms and industries with higher financial dependence should grow faster if they have access to financially developed markets.

A study by the European Commission (Gianetti and others, 2002) used this methodology to estimate the growth benefits of European integration. The authors estimated the contribution of financial development to industry growth across the world and just across the European Union. They found little difference between the two estimates, suggesting that financial development affects industry growth in similar fashion across the world. The authors then simulated how fast each industry in each EU country would grow if it had access to markets as financially developed as in a benchmark economy (e.g., the United Kingdom). For any given EU country, they then aggregated across industries to derive country-wide growth estimates. These varied significantly, depending on both the current level of financial development and the composition of industries. Consistent with the predictions of Rajan and Zingales, however, all countries less financially developed than the benchmarks stood to benefit from integration, with the most financially dependent industries and the least financially developed countries benefiting the most.

Sources: Country authorities; and Fund staff estimates.

1 Size of bubble indicates country GDP in U.S. dollars

Sources: Country authorities; and Fund staff estimates.

Applying the results of these studies to the Caribbean can provide some useful insights. For several Caribbean industries, we used the coefficients derived by Gianetti and others for industry growth from their world-wide sample and the measures of financial dependence derived by Rajan and Zingales to estimate how fast that industry would grow in each Caribbean country if it had access to markets as financially developed as in Barbados. We then took simple averages across the industry-level growth rates thus obtained to derive country-specific growth estimates for each country (see below).

The results can only be considered illustrative because (i) Caribbean technologies may differ from those elsewhere, leading to different levels of financial dependence; and (ii) all Caribbean countries do not have the same (and only just) the set of industries and in equal proportion that we are implicitly assuming. However, while the magnitude of the growth estimates may be uncertain, the direction is less so. Varying the financial dependence assumption for the Caribbean by one standard deviation in either direction, for example, leads to growth increase estimates in the range of 0.3–0.9 percentage point.

Financial integration also improves economic welfare by enabling consumption smoothing. While all the growth benefits of integration may already be captured by the financial development channel, integration also confers nongrowth economic benefits by enabling countries to take advantage of asymmetries in economic cycles and to pool risks. First, integration helps countries channel savings abroad in times of excess and borrow in times of need, so that even if the average amount of savings (and therefore investment and growth) remains unchanged, consumption becomes smoother, which directly contributes to welfare. This is particularly relevant for the Caribbean where the national savings cycle of Trinidad and Tobago, a major energy producer, is asynchronous with that of the rest of the (energy-importing) Caribbean. Second, as regards risk pooling, Caribbean countries as a group are very prone to severe natural disasters but at most only a subset of them experience such disasters at any given time. Cross-border investments, therefore, reduce the variability of returns over time, which is beneficial even if it is not necessarily accompanied by higher average returns.

Integration by itself is not sufficient to generate higher growth—concomitant macroeconomic and structural reforms may be necessary. Economic growth is driven by either increases in the factors of production or productivity improvements—financial development, thus, facilitates increased production but does not directly do so itself. For such facilitation and, hence, growth, strong institutions are critical to realizing the benefits of financial integration. For example, if judicial enforcement of creditors’ property rights is poor, foreign banks are as unlikely to lend as are local banks. And if red tape is extensive, businesses will not invest even with increased access to capital. Similarly, accounting standards and disclosure requirements, supervisory capacity, and market infrastructure are all important (see Sections E and F). Second, weak macroeconomic positions may impede financial integration from leading to greater investment—for example, if high debt levels lead to concerns among investors about macroeconomic and hence financial stability, or if the increased financing made available by integration is “captured” by the state for government consumption.

A further caveat is that regional integration should be a means to, not a substitute for, global integration. All of the benefits from regional financial integration outlined above also apply in the case of global financial integration, but even more so. Fundamentally, accessing financial markets that are even more developed than the most developed in the region can increase firmlevel and national growth further. For example, using the United States instead of the United Kingdom as the benchmark, the EU study finds annual average European growth to increase by just under 1 percent (instead of ¾ percent) per year and we similarly find Caribbean growth to increase by 1.8 percent per year instead of 0.6 percent if the United States is selected as our benchmark (instead of Barbados). Indeed, there is a danger that by erecting extraregional walls even as intraregional ones are being brought down, inward-looking regional integration may, over the long run, impede the growth of those countries that would naturally have developed extraregional financial linkages. At the same time, commonalities (in existing legal frameworks for example) as well as greater availability of local information (about clients and risks) and scale considerations may make regional integration easier than immediate global integration. But the fact remains that the ultimate objective should remain global integration and countries should seek to reduce extraregional barriers to financial linkages at the same time that they reduce intraregional ones.

D. The Current State of Financial Market Integration

Financial markets in the Caribbean are still relatively fragmented although integration has been increasing and markets are closely linked through ownership channels. The existing empirical literature employs three broad approaches to measure integration: (i) examining price-based indicators such as interest parity; (ii) examining quantity-based indicators such as gross capital flows and savings-investment correlations; and (iii) assessing regulatory or institutional factors. Data availability is a significant issue in the Caribbean—the absence of country-pair information on capital flows limits the assessment of quantity-based indicators. Likewise, the absence of forward exchange markets hinders the analysis of bond market integration by making it difficult to disentangle price movements in different markets into those being driven by exchange rate factors and those driven by interest rate movements. Nevertheless, it is possible to arrive at meaningful conclusions by examining each financial market segment (banking, bond market, stock market) in turn and by deriving a macroeconomic measure of regional financial integration.8

Banking

Large regional banks dominate Caribbean markets (Figure 2.1). The share of bank assets held by foreign banks averages about 60 percent—most of it by regional conglomerates or extraregional foreign banks with extensive regional presence. This share is high from a cross-regional perspective, given that European banks operating in other EU countries account for less than a quarter of union-wide bank assets (Figure 2.2). Central America also has regional banks but the extent of dominance, as measured by share in total bank assets, is limited at one third (Brenner and Morales, 2006). While large Latin American countries, in particular Mexico and Argentina, have overall foreign bank ownership at rates comparable to the Caribbean, the banks are mostly from outside the region, with the stakes of regional banks at low single digits (IDB, 2002).

Figure 2.1.Market Shares of Regional Banks in CARICOM

(In percent of bank assets, 2004)

Sources: Country authorities and Fund staff estimates.

Figure 2.2.Foreign Ownership of Banks 1

(In percent of bank assets, unweighted average)

Sources: Country authorities; and Fund staff estimates.

1 2004 for Latin and CARICOM countries, 2003 for ECOWAS, 2001 for Asia, a nd 1997 for EU countries.

Cross-border banking is, however, less extensive than cross-border bank ownership (Figure 2.3). Foreign assets and liabilities of CARICOM banks account for about a quarter of their assets, with most of the transactions likely to be vis-à-vis countries in the region.9 The share is higher than those in Latin America and West Africa but far lower than in the European Union, and contrasts with the dominance of foreign ownership of Caribbean banking. This result also contrasts with the European Union, where cross-border transactions play an increasingly prominent role since the creation of a single capital market.

Figure 2.3.Foreign Ownership and Foreign Liabilities1

(In percent of bank assets)

Sources: Country authorities; and Fund staff estimates.

1 2004 for Latin and CARICOM countries, 2003 for ECOWAS, 2001 for Asia. The reference year for EU countries is 1997 as EU country banks’ foreign liability data for later years are not comparable with those of other country banks.

The high degree of cross-border ownership in the Caribbean reflects regulatory barriers. While bank-to-bank cross-border transactions are allowed, cross-border provision of financial services to nonbank clients is largely prohibited in the region. Large regional financial groups, in particular two banking groups from Trinidad and Tobago, have, therefore, expanded their operations regionally through establishment of new entities in neighboring countries or mergers and acquisitions (Rambarran and Elbourne, 2006).

Bond markets

Bond markets in the region are dominated by government securities. The dominance reflects the high public sector debt of most CARICOM countries. At end-2004, public debt-to-GDP ratios of regional countries averaged about 100 percent. There is, however, a stark difference between Trinidad and Tobago (which has relatively low debt but a high share of regional output) and the rest of the Caribbean. All in all, aggregate public debt is about 75 percent of aggregate regional output, with Jamaica’s debt alone accounting for 40 percent of total outstanding public debt of regional countries.

The creation of a regional bond market centered in Trinidad has encouraged cross-border holding of bonds (Figure 2.4). Access to cross-border funding eased with the increase in oil-related liquidity in Trinidad and Tobago and capital account liberalization in larger Caribbean countries. Trinidad’s regional bond market issued US$850 million between 1997 and 2006. The fund-raising takes the form of direct listing by regional governments or, more often, issuance of derivatives (certificates of participation/interest) of government paper originally underwritten by regional financial institutions. Foreign issuers, mostly public sector borrowers from smaller CARICOM countries, accounted for about a quarter of all bonds issued in Trinidad and Tobago during fiscal year 2005, up from 5 percent in 2000. More recently, an Eastern Caribbean Regional Government Securities Market has been established to develop an integrated bond market in smaller Eastern Caribbean countries but activity there remains nascent.

Figure 2.4.Public Sector Debt Financed by Other CARICOM States, end-2005

(In percent of total)

Sources: Country authorities and Fund staff calculations.

However, within-region offshore borrowing remains small compared with extraregional borrowing. In 2005, CARICOM borrowers issued Eurobonds totaling US$1.6 billion, which is five times as large as all bonds placed by regional issuers in Trinidad and Tobago that year.

Regional interest rates, while converging recently, remain largely uncorrelated (Table 2.5). The rolling 12-month correlation of exchange rate—adjusted Treasury bill rates of CARICOM countries was, on average, 0.2 over the last five years. This correlation is considerably lower than those of EU and ECOWAS countries. The numbers are largely invariant to assumptions about exchange rate expectations, partly in reflection of the recent macroeconomic stability in the Caribbean.

Table 2.5.Interest Rate Correlations (Jan. 2000–Dec. 2005)
Assumptions about exchange rate expectations
Backward-Looking (1)Perfect Foresight (2)Combination of (1) and (2)
CARICOM
T&T-Other CARICOM 10.20.20.2
T&T-USA0.91.00.9
ECOWAS
Ghana-Other ECOWAS 20.60.20.3
Ghana-USA0.70.30.4
EU
Italy-Germany1.01.01.0
USA-Germany0.80.40.6
Source: Fund staff estimates.

The Bahamas, Barbados, Belize, Grenada, Guyana, and Jamaica.

Gambia, Nigeria, and Sierra Leone.

Source: Fund staff estimates.

The Bahamas, Barbados, Belize, Grenada, Guyana, and Jamaica.

Gambia, Nigeria, and Sierra Leone.

The dispersion in interest rates has narrowed but remains high (Figure 2.5). A common measure of convergence (called sigma convergence) looks at the standard deviations of treasury bill rates among countries. Over the last decade, the dispersion in rates has mostly been declining for six Caribbean countries but it still remains pronounced. Notably, however, dispersion has actually increased in recent years within the ECCU, reflecting diverging credit and inflation risks. The current level of interest rate disparity in the Caribbean is very large compared to the fully integrated government bond markets in the European Union, which closely monitors this variable as a measure of regional financial integration (Adam and others, 2002; and ECB, 2004).

Figure 2.5.Cross-Country Standard Deviation of Short-Term Interest Rate, Adjusted for Exchange Rates

Source: Fund staff estimates.

Equity markets

Caribbean stock markets are dominated by cross-listed stocks (Figure 2.6). Cross listing of CARICOM companies in the various national stock exchanges has increased substantially over the last decade and, in the process, has boosted market capitalization of individual exchanges. The cross-listed companies are among the largest in the region, are mostly financial sector companies, and represent some 40 percent of the consolidated regional market capitalization. In relation to the economy, the total capitalization of cross-listed companies amounts to 25 percent of regional GDP.

Figure 2.6.Number of Cross-Listings in Caribbean Stock Exchanges

Sources: Country authorities; and Fund staff estimates.

Price differentials of identical stocks listed in multiple exchanges are, however, large and volatile in CARICOM (Figure 2.7). Market data for cross-listed stocks indicate that the price differentials, or cross-market premia, in the Caribbean are on average 6–7 percent, which is much wider than those observed within the European Union and MERCOSUR (Figures 2.8 and 2.9). This is also larger than the average margin for cross-listed stocks between the United States and various emerging markets but similar to differentials among ASEAN stock exchanges.10

Figure 2.7.Average Cross Market Premium

(In percent)

Sources: Country authorities; and Fund staff estimates.

Figure 2.8.Equity Prices and Cross-Market Premia in CARICOM

Sources: Barbados Stock Exchange; Jamaica Stock Exchange; and Trinidad and Tobago Stock Exchange.

Figure 2.9.Cross-Market Premia in Various Regional Markets

Source: Bloomberg.

Analysis of cross-market premia movements over time provides further strong evidence of the low integration of Caribbean stock markets. Regression analysis shows that it would take about 18 trading days for half of the cross-market premia for the same stock to disappear between Jamaica and Trinidad and Tobago, and over 40 days between Barbados and Trinidad and Tobago (Figure 2.10 and Appendix 2.1). This common measure of price convergence, known as the “half-life,” is much shorter for stocks cross-listed in other markets.

Figure 2.10.Half-Life of Price Convergence

(In the number of trading days)

Sources: Country authorities; and Fund staff estimates.

The segmentation of Caribbean stock markets is so severe that low financial development alone cannot explain its extent. Lack of price convergence can sometimes reflect factors other than market integration. For example, even in a fully integrated national financial market, some price disparity could be sustained between two exchanges indefinitely because of underdeveloped market and trading infrastructure. In such situations, the poor infrastructure exacts such a large cost on trading between the two exchanges that arbitrage is not worthwhile. To see if this is the case here, we estimate for the various market-pairs the price differential below which no further convergence occurs (see Appendix 2.1 for details on the methodology). This “threshold” level is about 8 percent in the Caribbean, far greater than in other regions (Figure 2.11). More importantly, the convergence speed outside the threshold is also significantly slower in the Caribbean, reinforcing the finding of low integration. Market participants broadly attribute the stock price disparities to extremely low turnover associated with high concentration of stock ownership and to regulatory barriers, including a variety of trading and investment restrictions (see Section E). IMF staff estimates suggest that transaction costs alone—including taxes, commissions, fees, and implicit market impact costs arising from bid-offer spreads—account for about one-third of the no-arbitrage threshold level in the Caribbean.

Figure 2.11.Price Convergence

Sources: Country authorities; and Fund staff estimates.

Balance of payments data

The dynamics of the external current account can also provide information on the extent of financial integration. The key idea, originally applied to measure global (rather than regional) financial integration, is that countries that are less integrated with global financial markets are likely to have to adjust their external balances more quickly in the event of external shocks (Taylor, 2002). For any given country, the more binding the external financing constraints, the faster the adjustment speed and, hence, the less integrated with global financial markets. We extract a measure of regional (rather than global) integration by distinguishing between intraregional and extraregional trade flows in the econometric estimation (see Appendix 2.2 for details on the methodology).

The methodology relies crucially on a number of assumptions that may not always hold. A key assumption is that intraregional financial flows broadly mirror intraregional trade. There is both theoretical and empirical support for this assumption11 but it may not hold at all times or in specific contexts, including possibly that of the Caribbean. Second, the observed dynamics could be due to policy rather than financial integration (for example a shift in stance toward more swiftly correcting macroeconomic imbalances). Third, the measure examines net flows rather than gross flows—the latter (and hence financial integration) may have changed without affecting the former. Finally, by focusing on only goods, the methodology does not take account of financial flows associated with trade in services.

Subject to the above caveats, the analysis of intraregional trade dynamics broadly confirms the finding of low financial integration in the Caribbean. Empirically, the speed of current account adjustment is typically expressed in half-life (as for stock price premia). The half-life of regional trade adjustment is under 1½ years in CARICOM countries, about half of the duration in the Asian region and under a third of the adjustment time in the EU-15 (Figure 2.12). The speed is broadly similar that of ECOWAS countries but somewhat faster than for the MERCUSOR+5 grouping. This result is robust to some possible biases and data limitations.

Figure 2.12.Half-Life of Intra-Regional Trade Balance Adjustment

(1975–90 versus 1990–2005)

Source: Fund staff estimates.

The adjustment speed of regional trade balances slowed in the Caribbean after 1990, consistent with an increase in regional financial integration in the recent decade. The adjustment speed, as measured by the half-life, was less than one year in 1975–1990 when capital controls were widely prevalent in the Caribbean. However, it almost doubled during 1991–2005 (see Figure 2.12). This finding of increasing integration is again consistent with those from the analysis of bond and equity markets.

E. Barriers to Regional Financial Integration

Financial integration in the Caribbean, while increasing, has been hampered by both policies and infrastructure. Policies on exchange and capital controls obviously impact on integration, as do various regulations governing the functioning of financial institutions. Poor market infrastructure, such as the state of the payment and settlement system, can impede integration even with pro-integration policies in place. We consider these issues so as to draw policy conclusions about possible steps to encourage sound financial integration.

Financial liberalization and the CSME

The gradual process of financial liberalization undertaken by Caribbean countries since the 1990s has generally resulted in fewer exchange and capital controls. Starting in the early 1990s, foreign exchange markets were liberalized and exchange control regulations relaxed in Jamaica, and Trinidad and Tobago, and to a lesser extent in the ECCU and Barbados. The removal of controls has, however, also accelerated recently in the ECCU as part of its commitments to the CSME. The ECCU countries repealed the Exchange Control Act in late 2005 (which required, among other things, prior approval for outward remittances greater than about US$100,000) and Barbados is currently in the midst of liberalizing its capital account.

Generally applicable controls have, however, remained fairly extensive. For example, several countries require prior government approval for most categories of capital transactions, both inward and outward (Table 2.6). While in some cases these approvals have been granted liberally, the process raises transaction costs for all types of capital movements. In some Caribbean countries, government approval is still needed for clearing and settlement in specified currencies even for some current account transactions. And even in cases where controls have been eliminated on the books, they remained effective in practice. In the ECCU, for example, some financial institutions that are authorized dealers in the government securities markets appeared unaware of the repeal of the Exchange Controls Act even one year after the fact.

Table 2.6.Examples of Exchange and Capital Controls in the Caribbean, end-2005
De Facto Exchange ArrangementsExchange TaxCurrent Account TransactionsCapital TransactionsProvisions Specific to Financial Sector3
Trinidad and TobagoManaged floatingApproval required for inward direct investment exceeding 30 percent of the firm shares.Limits on institutional investors’ (insurance, pension funds, etc.) outward investments. Restrictions on purchase of foreign assets including capital market securities.
JamaicaManaged floatingLimits on institutional investors’ (insurance, pension funds, etc.) outward investments.
SurinameConventional pegApproval required for most nonimport external payments.Approval required for all transactions involving outward remittances of FX, and for local investment in real estate and stock market by nonresidents1Foreign transactions of banks are restricted to those undertaken for the account of their customers.



Limits on institutional investors’ (insurance, pension funds, etc.) outward investments.
BarbadosConventional pegApproval required for payments exceeding BDS$250000.Approval required for most securities transactions, credit operations, real estate transactions, and all direct investments.Approval required for banks’ foreign borrowing to finance their domestic operations



Limits on institutional investors’ (insurance, pension funds, etc.) outward investments.
BelizeConventional peg1.25 percent on FX purchasesApproval required for most securities transactions, credit operations, real estate transactions, and all direct investments.Restrictions on banks’ foreign and FX denominated operations. Nonresidents can only use offshore banks.
GuyanaConventional pegControls on all credit operations.Approval required for banks’ lending to nonresidents and lending locally in FX.
The BahamasConventional peg1.5 percent on outward remittancesApproval required for payments exceeding BDS$500000.Approval required for all outward capital transfers, which are restricted. Extensive controls on nonresident purchase of domestic shares, most credit operations and direct investments.Approval required for banks’ lending to nonresidents and lending locally in FX.
The ECCU2Conventional pegAlien holding license is requied for purchase of local real estate by nonresidents.Approval required for banks’ lending to nonresidents.
Sources: 2006 Annual Report on Exchange Arrangements and Exchange Restrictions and country authorities’ websites.

For CARICOM nationals, only registration is required within 30 days of purchase.

Refer to Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines.

For Belize, Guyana, The Bahamas, and the ECCU, information on controls on institutional investors outward investments is not available.

Sources: 2006 Annual Report on Exchange Arrangements and Exchange Restrictions and country authorities’ websites.

For CARICOM nationals, only registration is required within 30 days of purchase.

Refer to Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines.

For Belize, Guyana, The Bahamas, and the ECCU, information on controls on institutional investors outward investments is not available.

Controls on the cross-border activities of financial institutions remain extensive. Banks’ operations abroad and local operations in foreign exchange generally require prior approval by the authorities (see Table 2.6). There are also extensive controls regarding non-bank financial institutions, which particularly impact on market-makers and hinder the development of secondary markets. For example, in Jamaica, an exchange control regulation prohibits securities firms from dealing on their own accounts in foreign securities other than those issued by U.S., U.K., and Canadian sovereigns.

Finally, there are also specific regulations governing nonfinancial institutions that impede intraregional capital flows. For example, social security funds mobilize significant amounts of savings in the region, and could potentially play an important role in deepening the regional capital markets However, legislation in many member states does not allow for social security funds to be invested abroad, even within CARICOM (Table 2.7). In addition to impeding the development and deepening of regional financial markets, this restriction hinders the ability of financial institutions to spread out country risks, including with regard to hurricanes.

Table 2.7.Pension Funds’ Investment by Location, Dec. 2003(In percent)
LocalRegionalInternational
Anguilla77814
Antigua and Barbuda100
Bahamas100
Barbados9262
Belize100
Dominica100
Grenada919
Guyana964
Jamaica100
Montserrat433621
St. Kitts and Nevis9811
St. Lucia8974
St. Vincent and the Grenadines7921
Trinidad and Tobago100
Regional average90128
Sources: Country authorities; and Fund staff estimates.
Sources: Country authorities; and Fund staff estimates.

Several policy prerequisites are critical for the successful intraregional opening of the capital account. As highlighted at the outset of this paper, integrated capital markets increase countries’ and their financial institutions’ exposure to shocks. Therefore, to withstand and address this increased exposure, countries need to ensure that (i) their macroeconomic conditions and policies are sound; (ii) national monetary authorities have flexible market-based policy instruments to effectively manage domestic liquidity in the more volatile environment; and (iii) appropriate regulatory and supervisory frameworks are in place.

The current generally favorable economic environment presents an opportunity to make further progress in addressing macroeconomic imbalances to support integration. While there has been some consolidation, public debt in Caribbean countries remains among the highest in the world among emerging market countries (Figure 2.13). Caribbean external current account deficits, already large by international standards, have recently widened with the increase in global energy prices. Efforts taken by regional countries earlier this decade to strengthen fiscal balances appear to be running out of steam (Figure 2.14). Jamaica’s fiscal primary surplus, for example, while still substantial by international standards, has fallen by over 3 percentage points of GDP since 2003. Weak macroeconomic fundamentals risk undermining capital account liberalization even within CARICOM, which could severely set back regional financial integration.

Figure 2.13.Total Public Debt

(In percent of GDP, end-2006)

Sources: Country authorities; and Fund staff estimates.

Figure 2.14.Overall Fiscal Balances 1

(In percent of GDP)

Sources: C ountry authorities and Fund staff estimates.

1 Caribbean aggregate is a simple average; ECCU figure is a weighted average.

Capital account liberalization also requires increasing dexterity on the part of the monetary authorities. Liberalization heightens the sensitivity of capital flows to interest rate differentials. For countries with floating exchange rate regimes, it is, therefore, important to effectively exercise the flexibility that is inherent in the system to manage flows. Letting the exchange rate as well as interest rates move in both directions avoids creating incentives for markets to make one-way bets and hence reduces the risks of destabilizing capital flows in either direction. For fixed exchange rate regimes, higher volatility of capital flows will feed directly into domestic liquidity, making it all the more important for the central bank to have tools at its disposal to manage liquidity conditions effectively.

Therefore, countries need to ensure that their market-based monetary policy instruments are effective to manage liquidity in an integrated environment. Insufficient government paper for central banks to conduct open market operations has been an issue in some Caribbean countries in recent years. Moreover, minimum deposit rates (at different levels in different jurisdictions) remain in place that could potentially constrain the ability of central banks to manage the impact of intraregional capital flows.

Market infrastructure and requirements on trading

Notable progress has been made in upgrading and modernizing the trading and settlement system for equities. Jamaica moved in 2000 to electronic trading of equities, followed by Barbados in 2001 and Trinidad and Tobago in 2005. Central depositories have been in place since 2003 in all the stock exchanges, allowing to some extent efficient custody arrangements and timely transfer of shares across borders. The stock markets of Jamaica, Barbados and Trinidad and Tobago are currently in the process of being linked electronically. The ECCU launched its own securities exchange in 2003 on a modern trading platform and has also established its own depository for stocks.

Nevertheless, a number of structural weaknesses in infrastructure and regulatory requirements remain (Table 2.8). Some jurisdictions have not yet fully dematerialized government securities into electronic forms. No central depository exists for bonds in Jamaica, the region’s largest national debt market, and there is no electronic settlement, hindering the development of secondary market (Box 2.3). There also exist many differences in market rules and requirements. Listing requirements and tax treatment, for example, vary considerably across the national jurisdictions. A 2005 survey by the Trinidad Stock exchange shows that the inconsistency of financial reporting requirements posed a particularly onerous burden for market participants. Differences in national rules regarding corporate governance and treatment of collateral are likely to further dampen investor demand.

Table 2.8.CARICOM: Features of Key Securities Exchanges in the Caribbean, 2005
TradingListing requirementsDisclosure RequirementsExchange controlsWithholding tax
Days per WeekSettlement DatesCSD 1Minimum Share Capital (US$m equivalent) 2Minimum Public ShareholdingCARICOM InvestorsOther Foreign InvestorsCARICOM Investors 3Other Foreign Investors
Trinidad and Tobago3T+3Yes0.6325%Bi-annuallyNoYes0%20%
Jamaica5T+3Yes0.0020%QuarterlyNoYes0%25%
Barbados3T+3Yes0.500%QuarterlyNoYes0%15%
The Bahamas5T+3Yes1.0025%AnnuallyYesYes0%0%
Eastern Caribbean5T+1Yes3.7020%AnnuallyNoNo0%0%
Guyana1T+5No2.4920%AnnuallyYesYes0%15%
Sources: Caribbean Trade and Investment Report 2005 and stock exchange websites.

For Jamaica, CSD does not exist for fixed income securities.

For Barbados, it is the issuer’s minimum asset value.

The Double Taxation Agreements among CARICOM states provide for zero tax on dividends.

Sources: Caribbean Trade and Investment Report 2005 and stock exchange websites.

For Jamaica, CSD does not exist for fixed income securities.

For Barbados, it is the issuer’s minimum asset value.

The Double Taxation Agreements among CARICOM states provide for zero tax on dividends.

Box 2.3.Clearance and Settlement Systems in Selected Jurisdictions

Trinidad and Tobago

  • The settlement system is modern. A Real Time Gross Settlement (RTGS) system has been in place since late 2004. A custody and electronic settlement system is also in place for government securities including bills, notes and bonds.
  • Nonetheless, the legal framework for payments and settlement presents some important weaknesses. The legal basis is incomplete in that it supports paper-based payments systems but lacks the elements required for the operation of modern electronic payments system. Full contingency arrangements are also still to be finalized. A National Payment System Council was established as a forum of discussion on payment system matters, which should help in the final preparation of the required additional regulations.
  • While both equities and bonds can be traded electronically in the Stock Exchange, actual secondary trading, especially for bonds, seldom takes place. The Central Depository, established in 2003, provides record-keeping, custody and clearing. However, many fixed income securities issued earlier are not yet in the electronic registry. Neither is the central bank’s electronic bond registry linked to the Stock Exchange’s trading system. Overall, settlement of securities is slow, taking place in a T+5 framework.

Jamaica

  • The payment and settlement system is being updated. The Bank of Jamaica operates CIFTS (Customer Inquiry and Funds Transfer System) for large transactions among financial institutions. The CIFTS runs in a T+1 framework, which is slow and inefficient compared with the Real Time Gross Settlement system in Barbados and Trinidad and Tobago. The central bank is currently modernizing the payments and settlement infrastructure to bring the systems in line with international best practice, including by launching a RTGS system. A supplementary settlement system of Automated Clearinghouse (ACH), which is used mainly for smaller inter-bank transactions and takes three days to settle.

The trading and settlement systems for equities are more advanced than bonds. Equities are immobilized at the Central Securities Depository (CSD). Neither equities nor debt securities have, however, been dematerialized. Equities are traded electronically and transferred through book entry forms in the CSD, to which the trading system of the stock exchange is linked. A caveat is that securities should be blocked in the seller’s account before the trading, rendering short-trading impossible. By contrast, bonds are traded in an OTC market and remain in paper form throughout the transaction process, with transfers manually recorded on paper. Payments for bonds are executed through the CIFTS or by issuing checks. Given delays in check clearance (in principle, T+3), this exposes market participants to several risks including counterparty and operational risks, which are particularly pronounced for cross-border transactions.

Weak infrastructure and inconsistent requirements across markets add to transaction costs and, thereby, contribute to market segmentation. Brokerage commissions in the Caribbean, together with taxes, trading fees and other transaction costs, are estimated to exceed 1 percent of the transaction value, which is very high by international standards (Figure 2.15). This makes frequent trading, in particular arbitrage trading involving simultaneous buying and selling, prohibitively expensive.

Figure 2.15.Two-Way Trading Costs in Stock Markets

(In basis points)

Strengthening market infrastructure and harmonizing regulations will require steps at both national and regional levels. Individual jurisdictions will need to continue to strengthen their local market infrastructure, for example, by establishing central depositories for debt instruments where none exist currently. At the regional level, a concerted effort to harmonize listing and reporting requirements would help integrate stock exchanges and facilitate cross-border trading. Equally important is the establishment of common mechanisms and frameworks for cross-border transactions in the region. Key steps include establishing a common legal framework for enforcing crossborder collateral; creating a regional securities depository or a mechanism for linking the existing national depositories; and cross-border sharing of credit information. The establishment of a regional credit rating agency (CariCris) in 2004 is an important step in this regard.

F. Regional Supervision Issues

Financial integration poses special challenges for supervisors. Integrated markets allow shocks to spread across borders much more rapidly. Integration may also introduce risks that are not yet known and may render the assessment and management of risks more difficult by increasing the complexity and reducing the transparency of financial institutions. In parallel, growing integration between bank and nonbank activities creates a “blind zone” for bank supervisors, who usually have knowledge of, and jurisdiction over, a fraction of the operations and risks of financial conglomerates. This further compounds the challenges faced by supervisors as the conglomerates and mixed groups become increasingly organized less along jurisdictional lines and more along functional lines, motivated in part by opportunities for tax arbitrage across countries.

A regionally integrated financial system, as envisaged in the CSME, needs to be anchored by sound financial stability arrangements that address the related risks. Managing the integration process requires appropriate domestic and regional legal and regulatory frameworks; effective mechanisms for information sharing between domestic and regional supervisors; tested arrangements for cross-border supervision; clearly acknowledged home/host country responsibilities; and comprehensive strategies for contingency planning, crisis management, and resolution. CARICOM member states have made important progress in aligning regulatory and supervisory frameworks toward best practice, but challenges remain. These challenges are well recognized by national supervisory authorities, with most acknowledging that much remains to be done.

Platform for on-going supervision

Regional integration amplifies the need for adequate national supervisory systems, which are uneven in the Caribbean.12 Many supervisors lack sufficient operational independence. Some cannot grant and withdraw licenses, set legally binding prudential rules, or independently issue regulations. Risk-based supervision remains to be fully implemented, with compliance checklists often still in use, which prevent supervisors from developing a holistic view about banks’ risk-management practices and financial vulnerabilities. Similarly, accounting practices remain inconsistent (although CARICOM member states are committed to adopting international accounting standards) and licensing regimes in some jurisdictions warrant strengthening. Weak national prudential norms and practices (capital adequacy, loan classification/ provisioning, large exposures, country risk, and market risks) are, however, in the process of being strengthened, with a number of amendments recently passed in some jurisdictions and further substantive prudential changes anticipated during 2007–08.

Supervision of conglomerates remains a particular challenge. Preliminary results from an ongoing survey by CARTAC of financial supervisors in the region are illustrative. Seven of the 23 respondents to the survey do not have memoranda of understandings with other domestic agencies on consolidated supervision; 10 do not conduct any consolidated supervision and 18 had never conducted on-site inspections of financial conglomerates. Thirteen respondents also reported facing legal impediments on information sharing.

Recognizing the challenges posed by conglomerates, countries are taking steps to improve their supervision at the national level. Recent legal amendments enacted in Trinidad and Tobago allow information-sharing for the purposes of consolidated supervision and steps are being taken to require financial holding companies (FHC) to be licensed; mixed-conglomerates to restructure by establishing FHC; and prudential norms to be applied on a consolidated basis. Similarly, Barbados has embarked on a project to improve prudential information by requiring more granular data from financial institutions and is working on developing guidelines on consolidated supervision. In Jamaica, a review is underway to amalgamate various existing pieces of legislation governing banking type entities into a single consistent framework that is also expected to establish prudential principles governing FHC.

Framework for cross-border supervision

A Multilateral Memorandum of Understanding (MOU) among several (though not all) national supervisors was introduced in May 2004.13 This follows other ongoing efforts at regional cooperation in the area of supervision (Box 2.4). The MOU is structured to facilitate cooperation, consultation, and exchange of information. Some member states also have bilateral MOUs in place. The multilateral MOU addresses a number of critical issues, but there is scope for improvement in many areas, including crisis management, safety net and resolution issues, and supervision of cross-border conglomerates.

Box 2.4.Harmonizing the Regional Supervisory Architecture and Practices

Harmonization of supervisory architecture and practices has been a key agenda item of the Caribbean Group of Banking Supervisors (CGBS). The CGBS, alone and jointly with the Financial Stability Institute, has been arranging regional technical assistance in the application of new and/or emerging international supervisory standards such as consolidated supervision and Basel II. A CGBS technical working group has a specific mandate to harmonize laws and supervisory standards across the region; harmonize the approach to the restructuring of financial groups; develop a standardized accounting and reporting framework; improve information sharing between regional regulatory agencies; and arrange thematic regional training seminars and regional supervisory conferences.

There has been notable progress in information sharing across regulatory agencies. A CGBS database, which is accessible to all CGBS jurisdictions, provides comprehensive and chronological information, including details of the ongoing work of the Harmonization Project, enhancements of legal and supervisory structures, methodologies, procedures and practices, prudential data reporting arrangements, and status on publication of prudential data by respective member regulatory authorities.

Progress is also being made in the harmonization of supervisory standards. The Group of CARICOM Central Bank Governors has recently endorsed the following principals proposed by the technical working group1:

  • Ensure cross-jurisdictional consistency in regulatory reporting and definitions, inclusive of the definitions of what constitutes “capital base” and “acceptable group structures,” in order to avoid regulatory arbitrage.
  • Empower regulators to prescribe in legislation the accounting treatment to be used for reporting to the regulator for prudential purposes (especially in instances where conventional accounting treatment or IFRS standards are at variance or inconsistent with more stringent prudential standards promoted for deposit-taking entities).
  • Ensure consistency between the approach taken in amending legislation for consolidated supervision and the revised Basel Core Principles.
  • Enhance further the relationship between the Regulator and the External Auditors for risk-based supervision to be conducted efficiently, since regulators must be able to rely on the work of the external auditors.
  • Establish legislation to address the entry protocols and scope of foreign regulators, who wish to perform on-site examinations in member jurisdictions.

Further progress, however, needs to be made in many other areas. Key challenges identified by the CGBS include harmonizing holding company legislations in ways to grant powers to regulators to supervise holding companies and the operations of the entire group on a consolidated basis; adopting regional agreement regarding the appointment of a lead regulator where relevant; and establishing better legal and other arrangements to facilitate information sharing between supervisory authorities. The CGBS has concluded that a harmonized regional approach would have to accompany individual country efforts to establish an appropriate framework.

1 Opening Remarks by Audrey E. Anderson, Senior Deputy Governor at The Financial Stability Institute & Caribbean Group of Banking Supervisors Regional Seminar on Conglomerate and Consolidated Supervision, April 11–13, 2007.

Crisis management preparation warrants further strengthening. There is no common regional early warning system. Most individual supervisory agencies in the region do not have sufficient data on financial conglomerates and their cross-border transactions, making it challenging to trace linkages between institutions and countries. This information is necessary to map potential systemic vulnerabilities and to perform a comprehensive analysis of possible contagion. Also, legal frameworks for domestic interventions have been strengthened in a number of jurisdictions but measures should be mapped out to deal with potential cross-border crisis situations. Similarly, remedial measures have been identified at the national levels but steps have not been taken to assess, harmonize, or reconcile remedial enforcement rules and practices across the region.

Coordination on safety net and resolution issues should be strengthened. There are three national deposit insurance schemes operating in the region (Bahamas, Jamaica, and Trinidad and Tobago). However, there are differences in coverage and definitions and there are no burden-sharing arrangements to handle the failure of a regional bank. Similarly, national central banks traditionally provide emergency liquidity but member states have not yet developed a regional plan on how the lender of last resort principle would operate in a regional context. Finally, national bankruptcy legislation and insolvency proceedings need to be reconciled to deal with the potential of a regional bank or group failure.

The initial focus on creating a stability framework for the core cross-border conglomerates should be useful. These entities have complex cross-border and cross-functional operations (Figures 2.16 and 2.17), requiring cooperation of not only bank regulators but also securities, insurance and other supervisors across the Caribbean. A comprehensive stock-taking of the regional systemic implications of the conglomerates would help pinpoint the specific challenges to regional supervision broadly identified in the preceding two paragraphs.

Figure 2.16.First Caribbean International Bank Group Corporate Ownership

(as of June 30, 2004)

Figure 2.17.Colonial Life Financial—Organization1

Source: Annual Reports.

1 The figure is intended to indicate the wide sectoral and geographic range of the group’s activities and the complexity of some of its holdings rather than providing a comprehensive listing of all group affiliates. Two group sub-holding companies, Clico Securities Limited and Investors Holdings Limited, are not shown.

G. Conclusion

Financial integration is proceeding apace in the Caribbean. National financial sectors are large and complex in CARICOM countries. Linkages are close when measured in terms of ownership—a distinguishing Caribbean feature is the dominant role played by regional financial conglomerates that have extensive cross-country holdings comprising commercial banks, merchant banks and securities dealers. However, linkages in terms of financial flows, while growing, are still lower than in some other regional blocks in the world. The establishment of the Caribbean single market and economy is expected to further boost regional financial integration.

Integration can lead to substantial benefits, but realizing them requires initiatives along several fronts. It will be important to ensure that regional financial integration occurs as part of a process of, rather than a substitute for, countries’ global integration; regional integration should, therefore, not lead to an increase in extraregional barriers. Structural reforms to strengthen the business environment will help ensure that regional financial integration leads to financial development, without which the growth benefits of integration will not accrue. Macroeconomic policies will need to be geared toward strengthening fundamentals and ensuring flexibility. Finally, integration poses a special challenge for financial sector supervisors who should invigorate efforts at regional cooperation and coordination, especially with regard to the supervision of conglomerates, while they continue their efforts to strengthen oversight at the national level.

Appendix 2.1. The Dynamics of Cross-Listed Stock Prices

The cross-market premium for cross-listed stock prices is defined by

where ER1 and ER2 are the exchange rates of country 1 and 2 (local currency per US$), and S1 and S2 are the stock prices in the regional markets, in local currency.

The stock prices are transaction, rather than quoted, prices of a cross-listed stock at the end of each trading day. We have excluded the prices of a stock for certain days when the stock was not traded or traded only in one of the two exchanges, in order to control for the effect of illiquidity on the speed of price convergence.

We run autoregressive regressions, correcting for both conditional hetero-scedasticity and serial correlation. For that, we apply the maximum likelihood estimator on the following GARCH(1,1) model:

where the first equation is the mean equation for the price premium, and the second the variance equation of GARCH models, with one ARCH lag (coefficient α1) and one GARCH lag (coefficient λ1). We include three lags of the dependent variable to control for the serial correlation in the data. We use the Quasi-Maximum Likelihood Estimator to account for the non-normality of errors that are evident from the Jarque-Bera test.

Our analysis of the premium dynamics is augmented by taking into account non-linear adjustment, which helps distinguish between the effect of underdeveloped markets and that of low financial integration. For that, we utilize the Threshold Auto-Regression (TAR) methodology, which was introduced by Tong (1978) and popularized by Obstfeld and Taylor (1997) for the PPP literature. Below is our TAR specification, based on Yeyati and others (2006):

where the first two equations refer to the GARCH dynamics of the premium, while the last two equations define the dummies Iin and Iout that divide the explanatory variables into two samples. As before, the first equation is the mean equation while the second equation is the variance equation characteristic of GARCH models, with one ARCH lag (coefficient α1) and one GARCH lag (coefficient λ1). The threshold c is chosen optimally following a maximum likelihood algorithm. More precisely, for each c in a certain range, the likelihood of each model LTAR (c) is computed and the number that maximizes LTAR is chosen as the threshold. The TAR–GARCH model requires a long span of data to ensure convergence and robustness. Hence, the method is not of much use for short samples or highly illiquid stocks.

Appendix 2.2. Current Account Dynamics and Financial Integration

Taylor (2002) assesses the extent of global capital mobility over the course of the last 100 years, covering 15 major economies. Following the theoretical framework of Trehan and Walsh (1991) on the long-run budget constraint, the speed of adjustment of the current account to its equilibrium or steady state level is used as a measure of financial integration in the world economy as follows:

where cai is the current account balance in percent of GDP of country i in each region and λi is a country-dummy. The dummy is designed to capture unobservable time-invariant country effects, such as institutions. The error variable, εit captures shocks to the open economy resulting from a variety of sources: technology, tastes, monetary or fiscal policy, world interest rates, oil prices and so on. βi is taken as a summary statistic pertinent to the ability of countries to smooth shocks to saving and investment, and related to broadly defined transaction costs that might impede capital mobility. The intuition is that a country with good access to capital markets can finance current account deficits over several periods, whereas a country with limited access to foreign capital needs to quickly rebalance its current account due to the long-run budget constraint. Thus, a rapid adjustment would mean that current account deficits cannot remain open for long, and hence that financial integration is low.

We apply this concept to the regional level, following Bayoumi and Rose (1993), which examined the dynamics of regional savings and investment within the United Kingdom. We estimate the following partial adjustment model for 5 regional economic blocks (66 countries) over 30 years:

where cai* is the intra-region trade balance of country i in percent of GDP, which is computed by summing bilateral net imports of each country to other countries in the region. vt is a time-dummy, which captures the impact of unobservable time effects on trade dynamics such as regional economic crises or global liquidity crunch. cait−1 is the lagged extraregional current account balance, which intends to control for the effect of extraregional current account balances on intraregional balances (for example, an intraregional deficit can be covered by extraregional surpluses).

A variety of estimators, including the mean group estimator and the fixed effects estimator, were used to test the robustness of the above findings, in particular given possible distortions from small sample biases in the dynamic panel model. The generalized method of moments (GMM) estimator was also applied for subperiod regressions as a cross-check, given the Nickell (1981) bias of the fixed effects estimator in a short dynamic panel. The results on the regional level are robust to the choice of the estimators, although they are less so on the country level in part due to small sample biases in individual time-series regressions.

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1Some of the underlying analysis in this paper has been presented in regional fora and has also benefited from comments from some national authorities in the Caribbean.
2The treaty was finalized in 2001 and has so far been ratified by 12 out of the 15 members of CARICOM, which consists of 14 countries (Barbados, The Bahamas, Belize, Guyana, Haiti, Jamaica, Suriname, Trinidad and Tobago, and six Eastern Caribbean Currency Union countries) and the U.K. overseas territory of Montserrat. The Bahamas has opted out of some of provisions of the treaty; in particular, protocol II dealing with rights of establishment, provision of services, and movement of capital. Unless noted otherwise, the Caribbean or CARICOM in this paper refers to the 14 member countries of CARICOM.
3This study focuses on the 14 CARICOM states that are also IMF members (i.e., excluding Montserrat). Unless otherwise noted, “Caribbean” refers to the same grouping.
4Excluding Haiti and Suriname owing to the lack of data.
5For industry level studies see Rajan and Zingales (1998), Carlin and Mayer (1999), and Giannetti and others (2002). For firm-level studies see Demirgüc-Kunt and Maksimovic (1998) and also Giannetti and others (2002). Industry and firm-level studies conclude causality from financial development to economic growth with a reasonable degree of confidence. For studies using macroeconomic data, see King and Levine (1993a and 1993b), Levine and Zerbos (1998), Beck, Levine, and Loayza (2000a and 2000b), Demirgüc-Kunt and Levine (2001), Jayaratne and Strahan (1996) and Pelgrim and Schich (2002). These latter studies using macroeconomic data establish correlation and precedence rather than causality.
6This argument has been highlighted in Himmelberg, Hubbard, and Love (2002).
7Excludes Montserrat for lack of data. Barbados was selected on the basis of a measure of financial development that comprises the sum of bank credit to the private sector and stock market capitalization, both in relation to GDP. Other measures of financial development could also be considered, in which case countries other than Barbados, would be in the lead. This would affect the estimate of the magnitude of the benefits of integration but would not change the result that they would be positive.
8The off-shore financial industry is also sizeable in many Caribbean countries but it is not included in the data and analysis.
9In a survey conducted by the central bank, CARICOM countries account for 85 percent of Trinidad and Tobago banks’ loans and investment abroad (IMF Country Report No. 06/29). Information on the cross-country financial exposure of banks is not generally available in other countries of the region.
10See Yeyati, Schmukler, and Horen (2006) for U.S. emerging market differentials.
12This paragraph draws on Financial Sector Assessment Programs/Basel Care Principles for various countries in the region, completed during 2002–05.
13Signatories to the multilateral MOU are the Central Bank of Barbados; Central Bank of the Bahamas; Central Bank of Belize; Central Bank of Trinidad and Tobago; Cayman Islands Monetary Authority; Financial Services Commission, British Virgin Islands; Bank of Jamaica; Financial Services Commission, Turks and Caicos; and the Central Bank of Netherlands Antilles.

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