Financial sector consolidation: What risks lie ahead?

Thursday, 24 April 2014 00:00 -     - {{hitsCtrl.values.hits}}

The current headlining issue in the financial media of Sri Lanka is the financial sector consolidation mooted by the Central Bank of Sri Lanka (CBSL) through the ‘Master Plan on Consolidation of the Financial Sector,’ which deals with the consolidation of the banking sector and Non-Banking Financial Institutions (NBFIs) or finance companies. This consolidation plan comes in the wake of another CBSL-supervised finance company falling in troubled waters, namely, CIFL and prior to that the string of finance companies under the Ceylinco umbrella that met with a similar fate. The CBSL has put forward lofty objectives as being the drivers of this consolidation plan such as; creating a larger capital base, potential to finance large scale transactions, increased foreign investment, improved efficiency and profitability,increased range of financial services and more effective supervision of the financial sector. However, it cannot be overlooked that this plan succeeds the failure of several financial institutions in the recent past. Therefore, it is reasonable to surmise that an overarching objective of the plan is to address the existing weaknesses in the financial sector. In fact, the poster child for the consolidation plan of the CBSL, Malaysia, instigated its consolidation program after the1997 Asian financial crisis, which took a toll on its banking sector. Not a novel concept Financial sector consolidation is not a novel concept to the financial world; it is an approach that has been adopted by developed and developing economies alike, as a response to address weaknesses in the financial sector and reap the benefits envisaged in the aforementioned objectives of the CBSL. Many of these countries have yielded the desired benefits, such as Malaysia, and serve as a good example to propagate the strategy of financial sector consolidation. Another good example worth mentioning is Canada (despite any post-CHOGM animosity!). Canada’s banking sector is concentrated among five large banks (coincidentally the same number of large banks envisioned in the CBSLconsolidation plan), which account for more than 85% of the country’s bank lending. This has been highlighted as one of the main reasons Canada was able to avert a disruption in its financial system during the 2008 financial crisis; which battered the financial system of its rambunctious neighbour the US, leading to several high profile collapsesin the finance industry including the investment banking giant Lehman Brothers. Because of the highly concentrated nature of the banking sector the Canadian banks did not have to go in search of unconventional and risky business, did not get caught up in the credit fuelled derivatives transactions that the US financial institutions fell victim to; and remained consistently profitable on their traditional asset portfolios. If all these countries serve as a reference for the policy of financial sector consolidation (especially the ones highlighted by the CBSL in the consolidation plan, which are developing/emerging economies and more akin to Sri Lanka’s situation), the proposed consolidation in Sri Lanka’s financial sector is a welcome move to address the existing weaknesses in financial institutions and increase the service standards of the finance industry, which currently fall short of public expectations. However, it would be naïve to think that the proposed financial sector consolidation is without any riskand that Sri Lanka is in the same position as the counties that have benefited from this policy. The proposed plan According to the proposed plan, Sri Lanka is to have five large banks each with an asset base of over Rs. 1 trillion. Considering that at present the total assets of the banking sector amount to less than Rs. 6 trillion, the banking sector would be concentrated among these five banks. This would make these banks systemically important i.e. a negative impact at one of these banks could extend or spill over to the other banks and create a disruption in the whole financial system. In the Ceylinco saga, the difficulties at one institution triggered difficulties at other institutions; however within the same group and none of the financial institutions were systemically important that it disrupted the financial system. However, with the concentration of the banking sector among five large banks, difficulties at any one bank could put the entire financial system at risk. This systemically important status poses the problem of ‘too big to fail’. Because of the repercussions a failure of one of these banks could have on the financial system, the CBSL and Government would be compelled to intervene in the restitution of the bank. It would not be an option for the CBSL to let events unfold like in the case of CIFL, if it is to prevent widespread panic in the financial system. The CBSL would have to step in at first signs of trouble at any of these banks. After the collapse of Lehman Brothers, despite being an investment bank, the systemic shock caused by it resulted in a scurry by the Fed to rescue other systemically important financial institutions before troubled started to ripen at these institutions. The Fed provided AIG, one of the largest insurers in the world, a rescue package of $ 85 billion, to prevent the insurer from collapsing in the largestbailout in US history. Similarly, during the Eurozone financial crisis the UK Government provided RBS and Lloyds financial assistance in the form of capital and guarantee schemes amounting to a combined sum of £ 1 trillion, to keep these banks afloat and prevent a banking crisis. Even under an assumption that these five banks have par excellent risk management systems; a universal truth about banking is that no bank can survive a bank run i.e. where an overwhelming number of customers demand back their deposits. If you could recollect from your childhood memories of ‘Mary Poppins,’ it only took a fear that sprang from a little boy demanding his money back for a bank run to start on the ‘Dawes, Tomes, Mousely, Grubbs Fidelity Fiduciary Bank’. Therefore, a financial difficulty arising at any one of these banks is a plausible scenario that should be incorporated in the future crisis management plan of the CBSL. Potential bailout cost The next concern is how much it would cost for a potential bailout of one of these over Rs. 1 trillion asset banks.The amount of financial assistance needed would of course depend on the extent of financial trouble the particular bank is in, but it is reasonable conjecture that a bailout of one of these large banks would cost an unprecedented amount. The unsavoury truth of bailouts is that it is ultimately the tax payers who have to bear the brunt and with the creation of these five large banks, the tax payers stand to bear the risk of financing unprecedented bailouts. The safety net that the CBSL would have to lay out for these five banks in the form of bailouts or financial assistancewould lead to ‘moral hazard’; which means the safety net would encourage these banks and their officers to behave irresponsibly by engaging in risky business practices. One of the most vociferous arguments against the US bailout package during the 2008 financial crisis was that it promoted moral hazard among the top brass of executives of the troubled financial institutions. The public were of the opinion that it was the risky business practices and lack of good governance on the part of these executives that first lead to the failure of these institutionsand that the government bailout would give further incentive for these executives to behave irresponsibly. Coming to the situation in Sri Lanka, the recent failures of finance companies, if anything, has revealed that these companies and their officers were engaged in risky business models and lacked good governance. Considering that this was even without an assurance of a bailout or financial assistance, one could imagine to what an extent moral hazard would become an issue where the CBSL is compelled to provide a safety net for the systemically important banks. Merger between banks and NBFIs The other controversial proposal in the consolidation plan is the merger between banks and NBFIs. This implies the creation of a single corporate/legal entity engaging in both banking and finance business. The obvious legal ramification of this is the application of two district legislative and regulatory regimes (for the banking and finance business) to the operations of the single merged entity. This beckons the question whether the lesser standard of supervision applicable to the finance business would lead to regulatory arbitrage i.e. banking transactions being cloaked to appear as transactions coming within the purview of the finance business in order to circumvent the stringent regulations applicable to the banking business. Another risk is that the difficulties in the finance business could spill over to the economically more important banking operations. Therefore, the complex business structure created by the merger between banks and NBFIs would pose a challenge to the risk management framework of the merged entity as well as the regulatory and supervisory framework of the CBSL. Because the finance business could drag down the banking operations, the CBSL would have to step up its regulatory scrutiny of the finance business and not settle for a lesser standard of supervision as in the case of NBFIs. In the aftermath of the 2008 global financial crisis, as a regulatory response to systemically important financial institutions/too big to fail problem it was proposed that these institutions should be deconstructed in a policy known as ‘ring fencing’. What this policy essentially postulates is that risker business of banks such as investment banking activities should be legally separated from essential banking activities, so that the essential banking activities are ring fenced and able to operate on a standalone basis even if the affiliated business fails. However, the CBSL proposal to merge banks and NBFIs contradicts the wisdom of this policyby seeking to merge the business of banking and finance. If having systemically important banks is not enough, add this complex business structure to the equation, it would further increase the risk of these banks and the risk to the financial system. Risk management and regulatory frameworks In order to achieve the objectives of the consolidation plan of the CBSL and minimise the risks highlighted above, an appropriate risk management framework and a regulatory framework for banks and NBFIs would be of paramount importance. Countries like Canada and Malaysia have succeeded in their consolidation policy because they have in place appropriate risk management and regulatory frameworks that are able to managethe systemic risk created by the concentration of the financial sector. The CBSL in its plan has rightly emphasised the importance of these frameworks and highlighted measures to enhance these frameworks. However, these measures fail to acknowledge the systemically important status of the large banks and the complex business structure created by the merger between banks and NBFIs. In order to deal with the systemic risk posed by the large banks the CBSL should take a macro prudential approach to supervision i.e. focus on the financial and economic system as a whole rather than individual banks.This would enable the CBSL to proactively identify systemic risk and nip it in the bud. Further, the CBSL may need to consider adopting certain regulatory measures that go beyond Basel III guidelines. For instance, limits on asset-to-capital leverage to prevent unconstrained credit growth (asset bubbles); a measure that has proven success in Canada’s financial system. The proposal to merge banks and NBFIs leaves much to be desired in the absence of clarity over the modus operandi of the merger; however the CBSL could mitigate the risk by introducing internal walls/controls as a part of the risk management framework to ensure that trouble in the finance business does not spill over to the banking operations. It would be a gross misapprehension to think that the reduction in the number of financial institutions resulting from the consolidation would reduce the workload of the CBSL. The regulatory and supervisory function of the CBSL would have to be conducted at a much higher standard and require a higher level of technical skills. A clear inference to emanate from the proposed consolidation plan is that not only would it bring change to the manner in which the financial system stability mandate of the CBSL is exercised, but also give wider powers to the CBSL in the exercise of this mandate. (The writer is an Attorney-at-Law specialising in Financial Law.)

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