Running Head: The Century National Bank; Causes of failure and Treasury Management Concepts

A Study on The Century National Bank Ltd

University of Technology, Jamaica Western Campus College of Business Administration Treasury Management-FIN3010 Ms. Adian Miller April 18, 2013

Prepared by: Paula Powell 0908481 Ryan Wilson 0908827 Christopher Carvey 0908758 Jason Peynado 0903386

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Allocation of Tasks
Member Paula Powell Jason Peynado Christopher Carvey Ryan Wilson Task Executive Summary Background Introduction Recommended Steps Treasury Management Concepts Chronological Timeline Principal Causes for Failure Risk Management Objectives

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Table of Contents Content Executive Summary Introduction Background on Century National Bank Chronological Time line Principal Causes for Failure Literature Review Risk Management Objectives Treasury Management Concepts Recommendations References Page 4 5 5 6 8 11 11 13 18 20

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Executive Summary
This research paper was compiled in order to analyze the causes of the 1990s failure of the Century National Bank (CNB) in Jamaica. It provides the symptoms to look out for in case of another financial crisis and prescriptions for the prevention of further damage and contagion to the financial sector. Using a chronological timeline the study outlines the events which led to the failure of Century National Bank. Researchers used this timeline to evaluate and hypothesize that the main causes for failure were: Failure to comply with proper internal control procedures,

Liquidity problems which came about as result of issuing high-risk loans and later having a mismatch in maturities of the banks assets and liabilities, According to Crawford, the governments high profile and frequent audits of the banks account caused depositors to lose confidence in the bank and withdraw their money, leading to systematic risk. The intended audience for this paper which includes students, other researchers as well as any individual seeking information will benefit from an variety of risk management objectives and concepts such as credit risk, liquidity risk, operation risk and systematic risk which was experienced by Century National Bank

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Introduction
The Jamaican financial sector experienced significant difficulties during the years 19931997, mainly as a result of the Government's tight monetary policy, weak governance, poor central bank regulations, supervision and deficiencies in the management of the failed indigenous banks. Lack of confidence in the commercial banking sector produced runs on a number of smaller commercial banks. Some of the commercial banks were not adequately capitalized, because the regulatory authority took a proactive attitude toward supervision and the regulatory forbearance weakened the troubled commercial banks further (Swaby, 2011). These factors were identified as the reason for the crash of the financial sector In this paper the Century National Bank, one of the victims, is discussed.

Background on Century National Bank

The Century National Bank Ltd. was a financial institution licensed under the Banking Act of Jamaica. The banks operations were headed by Chief Executive Officer, Mr. Don Crawford. The institution went into foreclosure in 1996 along with its counterparts Century National Merchant Bank and Trust Company Ltd, a merchant bank licensed under the Financial Institutions Act; and Century National Building Society, a building society licensed under the Building Societies Act. In the view of the Bank of Jamaica the operations of these entities were characterized by unsafe practices. Despite attempts to correct perceived mismanagement; the position, in the view of the Bank of Jamaica became progressively worse. Long-drawn-out negotiations with a view to

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restructuring the institutions and improving their standing and placing them on a sound footing took place between the Minister of Finance, the Bank of Jamaica and the beneficial owners and senior management of the institutions. There was never a successful outcome to these negotiations (Century National Merchant Bank vs. Davies, 1998) This led to the collapse of the institutions, creating a negative effect on the banking sector. The questionable leadings of Mr. Crawford and his team and the possible recovery of capital lost are still being rectified in court.

Chronology of Century National Bank

Date 1990 Details The performance of the banking institutions was driven by high levels of inflation during 1990-95 and a credit boom in which many loans and investments were made with no proper risk assessment or appropriately valued collateral. The poor portfolio management and risk assessment bolstered profit making and disguised high levels of inefficiencies in the banking system. The environment facilitated profit-making through the transfer of funds between different types of institutions within a financial group. 1993 The commercial banks began to suffer the consequences of high liquid asset reserves and excessively high interest-rate structures. The cash-reserve ratio (CRR) ranged from 22 per cent to 25 per cent, and liquid reserve ratio (LRR) ranged from 47 per cent to 50 per cent. The lending rates of commercial banks were excessively high, ranging from 61.3 per cent

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per annum in 1993 to a low in 1997 of 44.22 per cent per annum.

1993

The commercial banks began to suffer the consequences of high central bank overdraft penalty rates. Under such adverse banking conditions, it is unlikely that any commercial bank would be able to assume interest rates of 120 per cent for overdraft facility by such magnitude.

1994

There were large margins within deposit and lending rates. Deposit rates ranged from 20.79 per cent per annum to 39.8 per cent per annum, based on the amount of deposit, as well as the maturity period. Lending rates ranged from 44.22 per cent per annum to as much as 61.32 per cent. The interest rate spread for commercial banks was 21.52 per cent in 1994 and then increased even further to 28.29 per cent the following year.

1993-97 The varying rates of interest offered on local deposit instruments, as well as fluctuations in

the foreign-exchange market, influenced the deposit structure of the banking system during the period 1993-97. A widening difference in the interest rates on time and savings deposits induced portfolio adjustments, thereby luring depositors to the more attractive savings deposits. The inadequate capital base and high level of non-performing loans in the commercial banks, in addition to government macroeconomic policies, poor management, inadequate central bank supervision, poor governance by boards of directors and shareholders, led to liquidity and solvency problems in a number of the indigenous financial institutions

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The overall health of the financial sector continued to struggle as a result of the Government's fiscal, debt, and monetary policies. The existing policy direction of increasing borrowing to reduce debt and fiscal deficits and to support high interest rates continued to lead to further consolidation, mergers, and bankruptcy of the sector and the economy. The asset portfolio of banks became heavily skewed towards government debt instruments and towards substantial support for other financial institutions, as opposed to productive loans and consumer-oriented credit.

Principal Causes of Failure

Century National Banks failure was mostly caused by the same reasons that caused the sector to collapse in the 90s. One of the reasons for failure was the fact that many banks including Century National Bank failed to comply with proper internal control procedures. It was reported that the former head of CNB Mr. Crawford, was allegedly found to have authorized substantial unsecured loans to companies in which he had an interest. CNBs high risk appetite, which was becoming very common among the local banks at that time, caused the company to suffer the outcomes of exposing to credit risk, resulting in the company becoming illiquid. The Century National Bank has also been allowed to run up large overdrafts at the BOJ to the tune of $ 4 billion which was still not able to meet their obligations. The Finance Minister at the time attempted to broker a deal with other indigenous institutions thinking that the merger would help with their current crisis. On July 10, 1996, an accountant from the accounting firm Price Water

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House was appointed the duty of managing the institutions book on the behalf of the Ministry. The examination confirmed that there was an excess of liabilities over assets in the amount of $2.5 billion. Additionally, it was noted that the Bank faced a big problem when it came down to the collectability of their issued loans. In addition, after further examination of the groups book, other problems were shown to be the reason for the bank failure. i. ii. iii. iv. v. vi. Deposit liabilities exceeded limits prescribed by law Unsecured credit to directors exceeded limits prescribed by law Credit to persons exceeded limits prescribed by law Board of directors presented misleading financial statements Depositors interest subordinated to owners via non-arms length transactions The board of directors and owners have failed to conduct the business of the respondent (CNB according to law in all respect and prudently on behalf of the depositors Liquidity was also a major cause for failure. In the section of the Edward Seagas biography published by the Jamaica Gleaner on June 26, 2011, he stated that CNB was a fast growing bank. He further stated that this event made clear the need for recognition of the fragility of the financial system, of the danger of overexpansion and the importance of careful and confidential handling of its affairs. Factors which also contributed to the liquidity problems

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were the bank was giving a lot of high- risk loans, bad loans and high interest rates, which was common throughout most of the indigenous banks in Jamaica at the time. Also, a large amount of money was unaccounted for. However, Don Crawford, former head of Century National Bank told RJR News on June 07, 2011; during an interview via internet during the FINSAC enquiry, that the reason for failure of the bank was caused by the government. Crawford informed the audience that the government did high profile and frequent audits of the banks account, which caused a lot of depositors to lose confidence in the bank and withdraw their money; up to $170 million in July 1996 alone. This rapid withdrawal of cash worried the BOJ, who advice the minister at the time Omar Davis to take control of CNBs operations. The reason given for the intervention by the government is that CNB outbid some of the other financial institutions and bought foreign currency from the American embassy for more than the exchange rate. On June 26, 2011 the Jamaica Gleaner published a section of Hon. Edward Seagas biography that, the CNB bid exceeded the unofficially proclaimed 'official' rate of exchange of J$22 to US$1 promoted by the Bank of Jamaica. CNB bid J$25.10. The government believed that CNB was degrading the Jamaican dollar. However, Mr. Crawford believed that the reason for the intervention was politically motivated.

Risk management objectives

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Risk Management is seeking security in an increasingly volatile world. Financial institutions assume risks in order to realize returns on their investments. There are six most common risks in banking i.e. credit, liquidity, market, operational, strategic and compliance risks. Credit risk arises from the potential that an obligor is either unwilling to perform on an obligation or its ability to perform such obligation is impaired resulting in economic loss to the institution. Secondly, Liquidity risk is the potential for loss to an institution arising from either its inability to its obligation as they fall due or to fund increases in assets without incurring acceptable cost or losses. Market Risk on the other hand is the risk of losses in on and off balance sheet positions as a result of adverse changes in market prices i.e. interest rate. This exists in both trading and banking books. Operational Risk is the current and prospective risk of earnings and capital arising from inadequate or failed internal processes, people and systems. Moreover, Strategic risk is the current and prospective impact on earnings. Capital, reputation or good standing of an institution arising from poor business decisions or improper implementation of decisions. Lastly, Compliance risk is the current or prospective risk to earnings, capital and reputation arising from violations or non-compliance with laws, rules, regulations and agreements. Risk management as commonly perceived does not mean minimizing risk, rather the goal of risk management is to optimize risk-reward trade-off. Therefore one of the main objective of risk management is to put in place an effective framework which can adequately capture and manage all risks the financial institution are exposed to. Risk Management entails four key processes:

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Risk Identification: In order to manage risks, an institution must identify existing risks or risks that may arise from both existing and new business initiatives for example; risks inherent in lending activity include credit, liquidity, interest rate and operational risks. Risk identification should be a continuing process, and should occur at both the transaction and portfolio level. Risk Measurement: Once risks have been identified, they should be measured in order to determine their impact on the institutions profitability and capital. This can be done using various techniques ranging from simple to sophisticated models. Accurate and timely measurement of risk is essential to effective risk management systems. An institution that does not have a risk measurement system has limited ability to control or monitor risk levels. An institution should periodically test to make sure that the measurement tools it uses are accurate. Good risk measurement systems assess the risks of both individual transactions and portfolios. Risk Control: After measuring risk, an institution should establish and communicate risk limits through policies, standards, and procedures that define responsibility and authority. Institutions may also apply various mitigating tools in minimizing exposure to various risks. Institutions should have a process to authorize exceptions or changes to risk limits when warranted. Risk Monitoring: Institutions should put in place an effective management information system (MIS) to monitor risk levels and facilitate timely review of risk positions and exceptions. Monitoring reports should be frequent, timely, accurate, and informative and should be distributed to appropriate individuals to ensure action, when needed.

Treasury Management Concepts

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There were many treasury management concepts that could have alleviated the problems that lead to the decline and ultimately the closure of Century National Bank. They include the following: 1. Liquidity Management Managing liquidity is a fundamental component in the safe sound management of all financial institutions. Sound liquidity management involves prudently managing assets and liabilities (on and off balance sheet), both as to cash flow and concentration, to ensure that cash inflows have an appropriate relationship to approaching cash outflows. This needs to be supported by a process of liquidity planning which assesses potential future liquidity needs, taking into account changes in the economic, regulatory or other operating conditions. Such planning involves identifying known, expected and potential cash outflows and weighing alternative asset/liability management strategies to ensure that adequate cash inflows will be available to the institution to meet these needs.

2. Risk Management This is the process of identifying, analyzing and either accepting or mitigating of uncertainty in investment decision-making. Essentially, risk management occurs anytime an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given their investment objectives and risk tolerance. Inadequate risk management can result in severe consequences for companies as well as

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individuals. For example, the recession that began in 2008 was largely caused by the loose credit risk management of financial firms. In other words, risk management is a two-step process - determining what risks exist in an investment and then handling those risks in a way best-suited to your investment objectives. Risk management occurs everywhere in the financial world. It occurs when an investor buys low-risk government bonds over more risky corporate debt, when a fund manager hedges their currency exposure with currency derivatives and when a bank performs a credit check on an individual before issuing them a personal line of credit. However, Century National Bank failed in its control of market risk and interest rate risk. Market risk is the risk that the value of an on and off balance sheet position of a financial institution will be adversely affected by movements in market rates or prices. The Bank could have made better use of mechanisms to stem its risk profile such as an interest rate mismatch ladder which shows interest rate balances by the time they are fixed, and gap limits which tells the ratio of interest sensitivity on the balance sheet for a given time period.

3. Financial Regulation Financial regulations are laws and rules that govern what financial institutions such as banks, brokers and investment companies can do. These rules are generally promulgated by government regulators or international groups to protect investors, maintain orderly markets and promote financial stability. The range of regulatory activities can include setting minimum standards for

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capital and conduct, making regular inspections, and investigating and prosecuting misconduct. The Bank of Jamaica (BOJ) is one of such regulatory bodies which serve to promote a safe and sound and an efficient and effective banking system. The newly amended Banking Act of 2002 has included in its regulation deposit- taking institutions, licensed under financial legislation administered by the BOJ, commercial banks, licensed near banks such as merchant banks, trust companies, finance houses and building societies. Additionally the BOJ helps the banking system to manage its liquidity effectively. Regulation by the Financial Services Commission brought into existence by the Financial Services Commission Act of 2001, takes a risk- based approach to managing and enforcing strict monitoring and supervision standards for the securities, insurance and pension schemes.

4. Capital Adequacy A measure of the financial strength of a bank or securities firm, usually expressed as a ratio of its capital to its assets. For banks, there is now a worldwide capital adequacy standard, drawn up by the Basel Committee of the Bank for International Settlements. The Basel Capital Accord, introduced from 1988, requires banks to have capital equal to a minimum of 8 per cent of their assets. In 2004, a revised framework, known as Basel II, was issued. Among its proposals are that those capitals requirements should be more risk sensitive and that greater use should be made of risk assessments produced by banks' internal systems. The revisions, which have sparked controversy, are being considered by national banking supervisors and implementation is due at the end of 2007.

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In Jamaica, the requirement of a Capital Adequacy is 10%. This requirement helps banks to have a sufficient enough buffer to absorb any unexpected losses and helps to reduce the risk of insolvency. 5. Management of the Banks Balance Sheet Bank balance-sheet management entails considering competing and conflicting objectives such as maximization of returns and minimization of risks associated with alternative portfolio combinations. Traditional multi-objective models simply provide the decision-maker with the entire set of non-dominated solutions; the decision-maker must then choose, unaided, the best solution based on his subjective trade-offs, experience and judgment. This paper develops an alternative multi-objective balance-sheet management model which allows the explicit incorporation of the decision-maker's trade-offs between conflicting objectives, and attempts to reduce his cognitive burden while ensuring that the solution obtained belongs to the set of nondominated points. Managing a banks balance sheet involves attracting the proper level of equity and debt into the bank and managing the banks liquidity. Two main tools usually used in managing liquidity include: the liquidity worksheet which is a cash flow analysis of the major sources and uses of funds and the liquidity summary which lists some of the common liquidity ratios used in the banking sector. A liquidity ladder is also used to measure and keep track of all the liabilities and assets in maturity order and by currency.

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6. Cash Management Cash Management is the corporate process of collecting, managing and investing cash (shortterm). It is a key component of ensuring a company's financial stability and solvency. Frequently, corporate treasurers or a business manager is responsible for overall cash management. Successful cash management involves not only avoiding insolvency (and therefore bankruptcy), but also reducing days in account receivables (AR), increasing collection rates, selecting appropriate short-term investment vehicles, and increasing days cash on hand all in order to improve a company's overall financial profitability. Cash management has to do with the proper forecasting, control and stewardship of an organizations financial assets from fraud, error or loss. Forecasting helps to control finances, manage liquidity and manage costs and can be done using any of three methods receipts and disbursements forecast, statistical forecast or correlation and regression. Internal control involves a series of checks and balances and monitoring transactions, cash flow and information within an organization

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Recommended Steps
The prudential regulation is regulation of deposit-taking institutions and supervision of the conduct of these institutions and set down requirements that limit their risk-taking. The aim of prudential regulation is to ensure the safety of depositors' funds and keep the stability of the financial system. To help prevent Century National Bank from failure there are prudential controls that could have been put in place to prevent systematic risk or reduce the chances of failure. The recommended steps according to the time line are as follows: 1. RegulationIn 1992 the government was strictly governed by the fiscal policy and free

market was highly prevalent. A free market is a market where interest rate is determined by demand and supply and there is little or no government control. Due to the absence of a regulator, banks act in accordance to what the board of the institution put in place as prudential controls. The role of the Bank of Jamaica is to promote the safety and soundness of the institution so they do not pose a threat or become a source of systematic risk. Century National would under the regulation of the bank of Jamaica comply with all laws and regulations including the imposing of new regulations set by BOJ. Follow the guidelines and performance standards set. BOJ would also provide guidance through best practice standards.

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2. Low Interest Rate- In 1993 the timeline shows that Century National has a high liquid asset reserve and high interest rates. A High Liquid asset reserve shows that Century National is putting too much of their profits into their reserve to deal with unexpected circumstances that may arise in the future. This high reserve is the effect of the high interest rates as the higher the interest rates the higher the reserve. This high interest rate and lending rate leads to default and counterparty risk. To control default and counterparty risk Century National could to set counterparty limits and establish exposure levels for each transaction carried out by the bank. The board should determine the overall risk appetite and exposure limit in relation to its market risk strategy. 3. CapitalThe mismatch of assets and liability was later diagnosed as an insolvency

problem. To manage insolvency Century National could have put in place regulatory capital requirement in place. The benefit of capital is that it provides a buffer to absorb unexpected losses, this would reduce insolvency even if management behavior does not change. These capital requirement are known as capital requirements rules, the higher the risk of the assets, the more capital is required. The Basel Committee on Banking Supervision implement capital requirement standards this is necessary where there is a institutions with high interest rates and lending rates as Century National Bank.

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Reference
Anonymous (2012) FINSAC: The Banking Sector: Why Governments Involvement? Retrieved on April 3, 2012 from http://www.finsac.com/about/assistance/banking/aboutthebankingsector.htm Anonymous. (2012) The Economy of Jamaica. Retrieved on March 31, 2012 from http://jamaica-guide.info/past.and.present/economy/ Seaga, Edward. (June 26, 2011) Contributor of his autobiography to the Jamaica Gleaner. Retreived on April 17, 2012 from http://jamaicagleaner.com/gleaner/20110626/focus/focus10.html Swaby, Neville. (June 21, 2011). Zooming in on the 90s Meltdown. The Sunday Gleaner, Jamaica- TheFocus. Retrieved on April 10, 2012 from http://jamaicagleaner.com/gleaner/20110612/focus/focus5.html