Not mixing apples and oranges: NBFIs to merge as subsidiaries of banks
Tuesday, 10 June 2014 00:36
The Central Bank of Sri Lanka (CBSL) unveiled its plan to consolidate the financial sector, specifically the banking and Non-Banking Financial Institution (NBFI) sectors early in this year, and now the process is making steady headway with the CBSL announcing in its latest press release on the subject that several financial institutions have already initiated the consolidation process. All banks and NBFIs have been requested to submit their final plans for consolidation by 30 June.
Since unveiling the consolidation plan, the CBSL and the banking industry have organised many events to educate the industry and all concerned stakeholders, including the public, of the consolidation process. One such event recently held was the MTI forum on financial sector consolidation, which saw the participation of the hierarchy of the CBSL and the banking industry.
Ambiguity in the consolidation plan
A controversy, however, arose at this forum over the comments made by the CEO of HNB regarding the proposal in the consolidation plan for a merger between banks and Non-Bank Financial Institutions (NBFIs). What initially seemed like a criticism of this proposal was subsequently clarified in the press as criticism to the merger of the two organisational structures and not the proposal to merge banks and NBFIs, where the latter would be merged as a subsidiary of the former.
The news that NBFIs would be merged as a subsidiary of banks is reassuring, because merging the two organisational structures would have been idiomatically similar to mixing apples and oranges.
Though, in the same financial intermediation industry, the banking and finance business has a completely different business model and ethos. The merger of the two organisational structures would have posed numerous challenges to the risk management of the entity and more so for the supervisory function of the CBSL.
However, the circumstances leading to this revelation is disconcerting. The critical comments made at the MTI forum regarding a merger of the two organisational structures, reveal that even the hierarchy of the banking industry was unaware of how the merger between banks and NBFIs would take place.
This begs the question what other important issues, at least, the industry ought to be aware of are grey areas, despite the unanimous support for the consolidation plan from the upper echelons of the industry!
This raises serious doubts in the minds of the public at a time of fragility in the financial system, given the spate of failures of finance companies and the recent additions; CIFL and the hybrid deposit/investment company, Touchwood. In order to restore public confidence and instil support for the consolidation process, the CBSL must reassure the public of the intent and outcome of the consolidation plan and not leave room for ambiguity.
The merger of NBFIs as a subsidiary of banks, though, reassuring in many aspects, raises some consequential issues.
An overarching criterion and objective of the consolidation plan is balance sheet expansion. For NBFIs the threshold is Rs. 20 billion total assets and for banks, other than the five large banks, the threshold to reach is Rs. 100 billion total assets. However, the merger of a NBFI as a subsidiary of a bank would not result in an increase of total assets of either the NBFI or bank (except by the amount of investment in the NBFI). This is because a subsidiary is an independent company, which has a separate and distinct legal personality from its parent company.
The creditors of a NBFI would not have recourse to the assets of the parent bank, and the capital of the bank would not be available to absorb losses of the NBFI.
This flouts the CBSL’s own criteria for consolidation and objective of increasing the asset base, at least in the case of a merger between banks and NBFIs.
Nevertheless, the other benefits of consolidation could be achieved; especially a weaker NBFI merging with a stronger bank could benefit from the superior management of the bank to turnaround its performance and deliver a better customer experience.
The parent-subsidiary structure is not without its inherent risk. A wholly-owned NBFI would represent a significant investment in the bank’s balance sheet and the two are bound to be interconnected through related party transactions.
These attributes increase the risk to the bank. Difficulties at the NBFI could cause a negative impact on the bank and even if the impact is not material, the psychological channel of transmission of risk could see depositors running to the counters of the bank at signs of difficulty at the subsidiary NBFI (this, of course, could happen the other way round as well).
This structure is an overture to a financial conglomerate and its risk. This structure could develop into a fully-fledged financial conglomerate through holdings in other financial service firms in the insurance or securities sectors (if the group has not already ventured into these sectors).
The CBSL proposes to limit the number of NBFIs a group could have to one, but there are no such restrictions for other financial service firms.
Financial conglomerates pose special risk to the financial system. A failure of one financial firm in a group could trigger a chain reaction of failures in the group due to the interconnectedness of the firms. Sri Lanka is no stranger to this domino effect after the Ceylinco experience. The more serious, however, is the systemic risk where the failure of the financial conglomerate could cause a disruption in the financial system and economy (of course the failure of a single firm in the group could precipitate into a full blown failure of the group).
Sri Lanka was fortunate that the Ceylinco fiasco did not escalate into a failure of the entire group including systemically important institutions like Seylan Bank, Ceylinco Insurance and The Finance. This was due to the CBSL/government intervention in these institutions after crisis struck the Ceylinco Group (except Ceylinco Insurance, which did not require such intervention).
After the 2008 global financial crisis, a debate arose in developed economies over the role of financial conglomerates in precipitating the crisis and a preponderant argument was that financial conglomerates should be deflated and dismantled. However, this argument may be somewhat premature for developing countries like Sri Lanka, where there is still capacity for improvement in the financial system.
An established group would be more willing and capable of providing related financial services, rather than a novice firm; not to mention the cost savings through competitive advantage and superior customer service.
Even developed countries have not fully discounted the advantages of financial conglomerates to the financial system and economy, despite the large bail outs spent on these conglomerates.
Alternatively, the regulators in these countries have preferred stringent risk management frameworks and regulation for financial conglomerates.
The CBSL proposal to have only one NBFI for a group may deflate the size of existing financial conglomerates (it would be interesting to see how this transpires, considering that certain influential groups own more than one NBFI). However, financial conglomerates would still exist and a potential merger between banks and NBFIs would facilitate the creation of new financial conglomerates.
Risk management framework for financial conglomerates
In dealing with the risk posed by financial conglomerates, the CBSL should consider taking a macro prudential approach to supervision where focus is on the financial system as a whole; so that financial conglomerates would be assessed as a group rather than the individual constituent firms (this approach would also assist in dealing with the proposed five large systemically significant banks).
Although, the CBSL has taken cognisance of the special risk posed by financial conglomerates in the financial system by appointing a ‘Working Group of Regulators for Financial Conglomerates’ comprising of the CBSL, Insurance Board of Sri Lanka, Securities and Exchange Commission of Sri Lanka, Accounting and Auditing Standards Monitoring Board and the Department of Registrar of Companies in 2007 (ironically before the onset of the Ceylinco crisis), it has not published the work carried out by this Group or for this purpose; at least in its ‘Financial System Stability Review’, which purports to be a comprehensive compilation of the work carried out by the CBSL in the exercise of its financial system stability mandate.
The BASEL committee, which is responsible for setting standards on banking supervision spearheaded the Joint Forum consisting of also the International Organization of Securities Commissions (IOSCO) and International Association of Insurance Supervisors (IAIS), which in 1999 issued the ‘Principles for the Supervision of Financial Conglomerates’.
An updated version of these principles was issued in 2012, taking into consideration the role financial conglomerates played in amplifying the global financial crisis.
These principles deal with powers and authority necessary for the multiple supervisors to perform group wide supervision; cooperation, coordination and information exchange among supervisors; corporate governance framework for financial conglomerates; capital adequacy on a group basis taking into account even the unregulated entities in the group and the risk they pose to the regulated ones; liquidity assessment on a group basis; and a comprehensive risk management framework to report and manage group wide risk including risk stemming from unregulated entities in the group.
To avoid another Ceylinco brand debacle with existing and any potential new financial conglomerates and to make the financial system more resilient, the CBSL should consider adopting these principles along with the regulatory measures proposed in the consolidation plan.