Reacting to the BAI scandal, Sushil Khushiram, minister of Financial Services during 2000-05, highlights the different lessons to be learned from this case. According to him, regulators should act in greater concert and deal with regulatory overlaps and gaps, amongst other things.
There is growing evidence of massive corporate mismanagement and fraud at the BAI Group, with some features of a Ponzi scheme also present. In the infamous Madoff case, not a single investment had been made on behalf of clients in 13 years. Like Madoff however, the BAI Group managed to hide losses for years, and hoodwinked the regulators by adopting equivocal accounting practices.
The Group’s true financial situation was concealed by a myriad structure of interlinked companies, displaying high and recurring fair value gains to systematically inflate investments. Consolidated financial statements at the domestic level were no longer available as from 2010, while a healthcare subsidiary was running sizeable defi cits. The consolidated accounts at the level of the ultimate holding company in the Bahamas now reveal huge annual losses, of over USD 100 million, in 2011 and 2012.
A common reaction to the crisis currently engulfing the BAI Group is to question the role of the regulatory authorities in ensuring proper oversight of the financial sector. It would be instructive therefore to review the various comments made by the IMF and the World Bank on the system of financial regulation.
IMF/WORLD BANK VIEWS
The various excerpts from IMF and WB reports, shown below (please refer to *WB ICP Assessment, 2012) , provide an objective standpoint to evaluate the performance of financial regulation and assess regulatory weaknesses. The IMF/WB recognize that the financial sector is equipped with a modern and advanced legal and regulatory framework, but highlight the need for closer cooperation between regulators, enhanced supervision and enforcement, and greater independence of regulators.
It is clear that the activities of the BAI as a financial conglomerate, engaged in both banking and insurance activities, was a long-standing source of concern. The insurance company offered investment rather than insurance products, made excessive related party investments, and presented solvency issues. The return to policy holders was unrelated to the performance of the insurance company’s assets.
A policy of forbearance, i.e., of restraint to allow the insurance company time to comply with the investment concentration limits, was considered as reasonable in the circumstances, presumably because the alternative option of drastic regulatory action might precipitate the advent of a major crisis. Whether forbearance was the right approach will be an issue for continuous debate as the BAI saga unfolds, with its daily lot of new and shocking revelations.
The IMF/WB pointedly underscored the importance of a joint regulatory strategy by the BOM and the FSC to address the systemic threat posed by the BAI as a financial conglomerate. BAI’s banking and insurance operations sustained an excessive concentration of investments in the Group’s related activities, which were mostly non-performing.
The first lesson of the BAI crisis is therefore for regulators to act in greater concert, deal with regulatory overlaps and gaps, and accelerate the process towards regulatory integration in the longer term. Regulatory cooperation should be expanded on a regionalbasis too, in view of the growth of cross border investments.
The second lesson is for regulators to adopt more intensive monitoring and supervision as well as stronger enforcement, instead of an informal and reactive approach, through frequent and detailed onsite inspection and offsite risk-based reviews. In support, the Financial Reporting Council (FRC) must ensure adequate financial transparency and disclosure by corporate groups in their audited accounts and reports. Developing further supervisory and enforcement capacity should become a key priority.
The third lesson is to strengthen the statutory independence of regulators so that regulatory actions are taken without influence from political and vested interests. Independent and well-governed institutions provide the best assurance for averting a crisis. A genuine policy of regulatory forbearance, balanced against systemic risks, can become dangerous and counter-productive when political factors prevail. Moreover, regulators should not only be granted statutory independence, but be perceived as truly independent.
The process of regulatory capture by politics is simple. X donates (more) money to politician Y, who leans on regulator Z to accommodate his new best friend. Following the 2005 general elections, the Chairman and Chief Executive of the FSC, and the Chief Executive of the FRC, were summarily replaced. Political interference deprived these nascent regulatory institutions of invaluable skills, causinga major setback to the establishment of an effective and independent regulatory regime.
The FSC adopted light-touch regulation, while the FRC went into hibernation. A politically-connected insurance conglomerate was thus relieved from strong oversight to pursue the expansion of its risky business without complying with prudential requirements, and in fi nancial accounting opacity. The Bank of Mauritius became even more subservient, and approvedthe grant of a banking licence to the Group in 2006, despite having knowledge of the reservations held about its insurance activities.
Ironically, the banking arm proved to be the Achilles heel of the Group, responsible for its collapse. In Trinidad and Tobago, deposit withdrawals from CLI Co Investment Bank similarly triggered the downfall of the related insurance business of CLI Co and BAI Co in Jan 2009. The resulting debacle of the CL Financial Group led to a Caribbean-wide financial crisis, which also required a Government bailout, at a potential cost of 10% of GDP in Trinidad and Tobago.
A widespread perception did prevail that the appointment of a Deputy Governor at the Bank of Mauritius was at the discretion of a financial conglomerate. Amendments to banking legislation seemed tailor-made to facilitateits business. In the wake of the 2014 Budget, the Banking Act was amended to relax the limitation on investments and non-banking operations, and allow financial institutions to buy, sell, hold or manage pools of assets. A credit book of hire-purchase clients could thus be securitized and sold to a bank as an investment product, to ease the bank’s lending without infringing on related party limits.
The mauritian banking and insurance sector is littered with the remains of failed banks and insurance companies that relied on the strength of political connections to cover up their dismal management and improper business practices, often shelteredby accounting irregularities. From Delphis Bank, to First City Bank, and on to Bramer Bank, the central bank was unerringly guided by a political hand in licensing banks destined to fail. Despite some recent disquieting signs, it is hoped that the cycle of regulatory capture will not resume anew.
BAI was a disaster waiting to happen. The role and responsibilities of the concerned regulators must be reviewed, and lessons drawn. We must seek to avoid, at all costs, a recurrence of regulatory failures, and protect the reputation of Mauritius as a financial centre and an investment destination.
Urgent action is required to foster closer cooperation between regulators, establish a clear roadmap for the integration of financial regulators, strengthen supervisory oversight and enforcement, and reinforce regulatory independence. Government could consider setting up a broad-based national committee of financial experts, and solicit IMF and WB support, to develop an action plan for achieving these goals.
What the IMF and the World Bank said
◗ FSAP 2003
A comprehensive and in-depth assessment of the financial sector, known as a Financial Sector Assessment Programme (FSAP), was first conducted by the IMF/World Bank at end 2002, and a report was published in Oct 2003. The overall assessment was favourable, with the observation that “the Mauritian financial sector is currently in good health, and the short-term stability risks are modest.” The Report noted that “Regulation and supervision of the insurance sector have improved markedly since the creation of the FSC, but further strengthening is required”. Deficiencies in the regulatory framework were considered as having been addressed in the draft insurance bill, but supervision needed “to place greater emphasis on risk management and early warning systems.”
◗ FSAP Update 2007
A FSAP Update was conducted by a joint IMF/World Bank mission in February 2007, as FSAPs are normally undertaken at five year intervals. The draft aide memoire then submitted to Government raised major issues relating to an insurance company - “The FSC conducted an onsite inspection of this insurance company in December 2004. The inspection found several breaches of current regulations. These included asset valuation issues and asset concentration in related companies as well as corporate governance and internal control deficiencies.
The company was asked to take steps to rectify the shortcomings. The company disputed some of the findings, in particular the finding that there is a significant deficit in the life fund.” The FSAP Update aide memoire was also very critical of the approval of a banking license to the Group to which this insurance company belonged – “Rather disconcertingly, despite its adoption of unsound investment principles, this financial group was granted “approval in principle” in late 2006 to obtain a license under the Banking Act by the Bank of Mauritius, without any consultation between the BOM and the FSC. The “approval in principle” concerned an entity that would be an affiliate of an institution whose activities have been the subject of the closest examination from the FSC.”
◗ FSSA Report 2008
Based on this FSAP Update, the IMF produced a Financial Sector Stability Assessment Report in Dec 2008, noting the progress made in the creation of a modern legal and regulatory framework with new insurance legislation enacted in 2005. The Insurance Act was still to be proclaimed though, pending the introduction of implementing regulations, including risk based solvency rules. The IMF Report 2008 recommended that cooperation between the BOM and the FSC be improved by activating and expanding the scope of the December 2002 MOU to ensure effective supervision of financial conglomerates, and to review governance of FSC for increased statutory independence.
It was also recommended to develop an early warning system, to strengthen intervention action when insurance companies adopt imprudent practices, and to reinforce the program of on-site inspections by focusing on assessing adequacy of corporate governance, internal controls, and risk management. The IMF Report 2008 held that the effectiveness of key regulatory agencies would be enhanced by improvements in their governance and management. It was noted that “at the Financial Services Commission (FSC), senior management and most of the Board were replaced following the last general election. Such a wholesale turnover in senior management and the Board could raise concerns about the independence of the regulator, and was undoubtedly disruptive to the ongoing operations of an important but young institution. In addition, two of the three director positions remain vacant. Both regulatory independence and the perception of independence are important for effective supervision. The authorities should consider granting greater statutory independence to the FSC…”
◗ *WB ICP Assessment, 2012
A World Bank mission was conducted in Mauritius in July 2011 for a detailed assessment of the observance of internationally recognized insurance standards, namely the 28 IAIS Insurance Core Principles (ICP), focusing on the supervision and regulation of the insurance sector and the role of the FSC. The WB Assessment, dated April 2012, found the insurance core principles were generally well observed. Of the 3 partly observed ICPs, Principle 17 requires that the supervisory authority supervises its insurers on a solo and a group-wide basis.
The Report commented that “The ICPs call for a more explicit approach to group issues than is the case in Mauritius and has been intensified as a result of international standard setters making revisions to their recommendations following the Global Financial Crisis. It is clear that some group wide risk exists in Mauritius and the insurers that operate such structures reported only limited awareness of any supervisory or regulatory constraint specifically arising with respect to these issues.” Although ICP 21 on Investments, relating to investment policy, asset mix, valuation, diversification, asset-liability matching, and risk management, was found to be largely observed, the Report added that “The FSC could consider a more intensive on and off site review of how insurers develop and maintain investment policies that support a financially sound condition and are consistent with their risk appetite, retention, and capital policies. This may lead to more specific requirements regarding diversification, matching, valuation, liquidity, credit and other risk management aspects if found to be necessary.”
The WB Assessment commended Mauritius highly, stating that “For a sector that has undergone a complete and quite radical renovation of its regulatory and supervisory arrangements, the Mauritian insurance sector and the FSC as supervisor have made exceptional progress”. Among the remaining challenges, the “risks of interconnectedness and connected parties” were identified, as is the case in small countries. The WB assessment recommended that “Supervisory intensity, however, is now the key priority. The FSC has been rightly focused on regulatory efforts. Because of geographic proximity, supervisory interventions have been more informal and reactive. With the regulatory effort complete, supervisory intensity can increase including through on site efforts and the development of off-site risk-based approaches in line with the current plans of the FSC.”
◗ IMF Report 2012
At the request of the Bank of Mauritius, an IMF Technical Assistance mission visited Mauritius in April-May 2012, mainly to provide advice on whether the FSC and the BOM should be merged to create a single regulatory authority. The IMF Report entitled “Financial Sector Reforms” of May 2012, concluded that such a merger was not desirable at the present time as the disadvantages largely outweighed the benefits.
The Report picked up again on the issue raised in the FSAP 2007 Update in relation to an insurance company: “A number of issues have arisen with respect to a particular conglomerate and which could arise in other cases. The 2007 FSAP Update report referred to a single insurance company with a substantial proportion of its assets invested in related companies and emphasised the need for this issue to be resolved. The mission found that the issue had not been resolved. The authorities have observed the issuance of single policy premium life insurance products by this company. These policies attract high bonuses and can then be cashed in. The FSC notes that such products have some of the characteristics of investment products, and the BOM suggests that they also have some characteristics of time deposits. It is important that the appropriate regulatory requirements should be applied, regardless of the name of the products.
In addition to these problems, the FSC was concerned that a banking license was given to a company in this same group by the BOM without proper consultation with the FSC, notwithstanding the issues described above. These issues have been evident to the authorities for some time. The failure to address them could be explained by the limited capacity of the FSC and the inadequate cooperation and coordination between the FSC and the BOM. Although the group may not pose a systemic threat, the issues are potentially serious for the policyholders, depositors and investors and the weaknesses that allowed the problem to remain unresolved for so long, could also result in more serious failure of a systemically more important institution.”
The Report further emphasised that there was no basis “for supposing that a single regulatory authority would have been better able to address this issue”. Instead, the IMF pressed for enhanced coordination between the BOM and the FSC, arguing that “the specific examples of difficulties that are being experienced are modest in impact and could be resolved with a reasonable degree of cooperation. The case of the particular group described above is also a concern but the mission considers that the present efforts to find a solution, enhanced by improved cooperation, should be allowed time to work.” The Report made a prescient recommendation that “The two authorities should also engage in joint “war games” in which they play out their reaction to a crisis in the financial sector. Contingency planning is very important, especially in a financial sector that has been lucky enough to avoid most real financial scandals. There would be advantage in devising a financial crisis scenario such as the failure of an insurance company, ……”
Following the IMF TA Report, the FSC appeared to stiffen its regulatory resolve towards insurance companies. The Solvency Rules 2007 under the Insurance Act were thus amended in 2013 to clarify that the investment limit of 10 percent of an insurer’s assets was applicable to one or more related companies of the insurer, in aggregate and not individually, and that investments included deposits, receivables and loans. The FSC also closed the tap on new fund raising by a Property Fund that was channelling finance to a related insurance group.
◗ IMF staff report 2014
The IMF Report under the annual Article IV consultation of May 2014 stressed the importance of collaboration between the two financial regulators. “The BOM should continue its supervisory efforts, including through FSC coordination. Rising non-performing loans, insufficient collateral values, and credit exposures to large borrowers might be of concern for banks, although it appears that most real estate lending was well-collateralized. Regular meetings between BOM and FSC have been held to address supervisory and statistics coordination issues.
The BOM and the FSC should continue to strengthen their collaboration, particularly on assessing the inter-linkages between banks, non-bank financial institutions and GBC sector, and regulatory overlaps and gaps.” The IMF Staff Report also confirmed that “The Mauritian banking system is well-capitalized and resilient against a range of shocks according to stress tests.
As Minister of Financial Services during 2000-05, Sushil Khushiram established the legal and institutional regulatory frameworks for the non-bank fi nancial sector, fi nancial reporting and corporate governance, and anti-money laundering. He introduced new Companies, Insurance, and Securities legislation, andset up the Financial Services Commission and the Financial Reporting Council.