Integrated financial authority must supervise financial conglomerates

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.