Integrated financial authority must supervise financial conglomerates

Fajar Hidayat, Financial Market Analyst, Jakarta

Establishing the Financial Services Authority Institution (FSAI) is one of the actions planned in the financial sector reform under the Indonesian Post-IMF economic reform program. The FSAI will be set up as a fully-integrated financial supervisor, authorized to regulate and supervise all types of financial institutions within the financial market, i.e. banking, securities companies, insurance, and others.

The FSAI blue print will be designed after the revision of the Central Bank Law (UU No. 23/1999), which is being processed by the legislature. The FSAI is slated to operate by 2008.

Ideally, an integrated financial supervisor exists in a country with a significant number of financial conglomerates that make up a large proportion of the financial market. As financial services become intensely integrated in the conglomeration, an integrated financial supervisor is needed to mitigate the risks of the conglomerates. Therefore, the FSAI should be prepared to regulate and supervise financial conglomerates.

A financial conglomerate is an integrated financial institution offering financial services diversification to maximize market share and profit. The conglomerates also carry risks due to the different characteristics of the financial services mix offered in commercial banking, insurance, and securities investment.

Banking activities are converting liquid short-term liabilities (deposits) into long-term assets (loans), which make banks vulnerable to credit risks and liquidity risks because of uncertainty in depositors' behavior and long-term loan commitments. The maturity mismatch between assets and liabilities exposes banks to interest-rate risks.

Insurance companies, in contrast, are converting long-term liquid liabilities into short-term assets, typically marketable instruments. They are, thus, not vulnerable to liquidity crisis, but exposed to market risks in their assets value, and catastrophe risks that require large payouts to their liability holders.

Securities companies have both short-term assets and liabilities, whose value is marked-to-market on a daily basis, reflecting their true financial position. Changing the market value of assets will be accompanied by a correction in the value of liabilities. Their assets are therefore robust to liquidity shocks with the main risks being in the market, i.e. excessive declines in assets values.

The different characteristics of the integrated financial services mean financial conglomerates are at risk of internal contagion, i.e. the transmission of financial problems among the various components of the organization. The level of risk (of contagion) depends on the organization model that financial conglomerates adopt, i.e. the universal-banking model, the bank- parent model, or the bank-holding-company model.

The universal-banking model enables the bank to engage in a financial services diversification within a single legal entity, which allows the pooling of resources between the bank's different activities. This model increases vulnerability to contagion risks because there are no institutional barriers between activities; e.g. losses in securities trading translate directly into losses for the bank as a whole.

In the bank-parent model, banking and non-banking activities are separated into subsidiaries within the banking group. This imposes some operational separateness between the activities conducted by the units; hence it locks up the bank's loss to its investment in the subsidiary in the event that subsidiary units fail.

In the bank-holding-company model, independent banking and non-banking subsidiaries are functionally separated and operate under a holding company's "umbrella", which oversees the portfolio of activities. In this model set-up the relationship between the bank and the non-bank subsidiaries is only indirect and therefore should have the least likelihood of contagion.

When a financial conglomerate operates through a complex and opaque structure -- especially in the universal-banking model and the bank-parent model -- the contagion risk may be difficult to mitigate if the management cannot adequately control the overall scope and level of activities. Furthermore, the complexity in structure may be intentionally set to circumvent regulatory requirements, particularly in the areas of capital adequacy and risk concentration.

In the United Kingdom (UK), for example, Financial Services Authority (FSA) was established in 1999 by merging eight functional financial supervisors and took over responsibility for banking supervision from the Bank of England.

FSA was established as a lead superviser, to supervise financial institutions as a group, rather than supervising the various functions of the institution separately. Financial groups in the UK have been broadly diversifying their financial services as well as integrating their management and controls on a group- wide basis and lead-supervision has developed in response to this.

According to Chairman of the FSA Howard Davies (1999), from a market point of view there are many advantages and benefits from a one-stop regulatory stop in the FSA model. Under the previous system there was a great deal of overlap: Securities companies, insurances, building societies and banks have gradually begun to all look alike, offering the same services and products, yet continuing to be regulated by different bodies to a large extent. A single regulator would add to the efficiency of regulation.

In Indonesia, financial conglomeration is still in the early stages and there are some regulatory limitations. The banks can adopt the bank-parent model or the bank-holding-company model by creating subsidiaries in non-banking financial services, but cannot adopt the universal-banking model. The 1998 Banking Law prohibits the banks to underwrite insurance products and common stocks transaction in the capital market.

Indonesian banks also can act as the sales agents of insurance products (bancassurance) and mutual funds that are produced by either the bank's subsidiaries or insurance and securities companies. The banks are allowed to become the sponsors of mutual funds with non-common stocks underlying assets.

Until now, at least 10 banks deliver bancassurance with the potential market at roughly Rp 13.6 trillion. There are also at least 15 banks offering mutual funds, mostly based on government bonds. Out of Rp 68.35 trillion in mutual funds selling up to June 2003, around 85 percent or Rp 58 trillion were sold via banking-distribution channels.

The current trend reflects a strong demand for financial services diversification. In the future, the demand might be even stronger as Indonesia gradually shifts from a savings-oriented society to an investment-oriented society.

Banks will have to diversify their business as they face intense competition from new types of liquid assets and yield attractive financial instruments provided by insurance and securities companies. In such a situation, financial deregulation might be unavoidable to allow more extensive integrated financial services diversification within complex financial conglomerate structures.

For that reason FSAI must ensure its competency to conduct regulations and to supervise financial conglomerates. FSAI should also be able to mitigate the risk of financial conglomerates in order to maintain the financial market stability.