Shamshad Akhtar: Pakistan - framework for consolidated supervision
Keynote address by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at the
Annual General Meeting of the Institute of Bankers, Pakistan, Karachi, 31 October 2008.
* * *
Financial markets have not only been growing at a rapid pace, but have also been marked by
continuous change. Key structural transformation has been the evolution of large and
complex global financial institutions and structures that, given their inherent size and
strengths, have promoted financial engineering and innovation, exploited new avenues of
financial leveraging accompanied by greater risk appetite, and infusion of information
technology. Together these developments have changed the financial landscape. Over the
period, various market developments along with few key legislative changes, such as
repealing of the Glass Steagall Act, 1933 (which rolled back the restrictions imposed on
banks for mixing their business with securities and investment banks) in the late nineties,
fostered new financial structures and strategic alliances that removed the distinction between
activities specific to various types of financial institutions. Though the recent global financial
market turmoil has triggered questions regarding the risks associated with the emerging
types of financial structures, however a more relevant debate is regarding the gaps and
weaknesses in the regulatory and supervisory structures that allowed over-leveraging and
the operations of several financial industry segments to operate without appropriate
oversight.
Recognizing the need to evolve an appropriate oversight policy mechanism for its evolving
financial structure, SBP, as a part of its overall financial sector reforms launched in July
2008, has advocated the need for legislature to empower the central bank to augment its
oversight of the financial sector. In my remarks this morning I propose to outline the
economic and financial benefits of financial conglomeration and the risk and supervisory
challenges arising out of these complex financial structures. I propose to then share with you
the legislative reforms launched by SBP in this area which have recently been approved, in
principle, by the Cabinet and are to be tabled for Parliament consideration.
Rationale for consolidated supervision
Worldwide, the process of change has allowed many financial organizations, which used to
engage in the primary business of banking, asset management or insurance activities on a
standalone basis, to adopt more flexible structures whereby banks opened up a wide range
of subsidiaries and affiliates that primarily engage in businesses other than their core
business. The main economic and financial benefit which encourages the formation of such
groups is the enhanced ability to achieve economies of scale and to capture synergies
across complementary financial services business lines. These synergies result in improved
operational efficiency and effectiveness due to lower costs, reduced prices, and improved
innovation in products and services. However, at the same time the emergence of such
groups has also added complex linkages and relationships among economic agents.
Consequently, they have also necessitated a paradigm shift in the supervisory approaches
all across the globe to assess, manage, and mitigate risks stemming from such
arrangements.
Like other countries, these developments have steadily gained momentum in the Pakistani
financial sector. The existing regulatory framework in Pakistan under SBP gradually became
more open, flexible and allowed the banks to set up subsidiaries to operate Non-bank
financial businesses. The prevalent structure under which non-bank financial services are
being offered is mostly through the parent - subsidiary form of structure wherein banks are
parent of their non-banking subsidiaries, or in some cases banks have Non-banking finance
companies (NFBCs) as associates. Some elements of Universal banking also exist, for
example banks are allowed to undertake investment banking, and leasing businesses on
their own balance sheet as well. While the central bank showed flexibility in allowing these
developments, the underlying legal architecture was not changed in line with the market
needs and developments.
As such, the current legislation and regulatory tools are not adequate to effectively address
the potential risks to the safety and soundness of the financial sector. The safety and
soundness of the banking sector, being at the core of all activities of the financial sector, is
critical for the general public, for the financial sector itself and for the economy as a whole.
The governing law of the banking sector viz. the Banking Companies Ordinance (BCO) was
introduced in 1962 and occasional changes were made in it in response to the challenges of
different phases of development. The significant challenges posed by universal banking,
large financial groups and holding company structures now warrant a matching legal
framework to avoid any major disruptions in the economy and in the process of financial
intermediation. Recognizing these challenges, SBP has sought in principle approval from the
requisite forums for amendments in the BCO to enable it to supervise banks, groups and
financial holding companies in line with international trends.
Besides forestalling various risks, these amendments would enable significant benefits in the
form of operational efficiency, lower costs, reduced prices and innovation in products and
services. Moreover, one of the Core Principles for effective banking supervision (CP-24)
issued by the Basel Committee on Banking Supervision requires that a banking supervisor
should be able to supervise the banking groups on a consolidated basis. Presently, Pakistan
is either compliant or largely compliant with all the core principles except those dealing with
consolidated supervision. The proposed amendments in the BCO would also enable
Pakistan to ensure compliance with this principle.
Major risks arising from complex structures and supervisory challenges
While the increasing integration and the drive towards financial conglomeration has opened
up possibilities of greater efficiency through increased economies of scale and scope, at the
same time it has also generated novel risks and has consequently raised a number of
supervisory concerns. A few of these risks and concerns are as follows:
•
One of the foremost risks is contagion risk which can manifest itself in
psychological as well as financial forms. Financial distress in one entity could impair
the reputation of the other entities and the market participants may be reluctant to
engage in business with them. The reputational problem can often lead to financial
distress in the entire group, as the parent or the other group associates may have to
help out the distressed entity in order to safeguard the group from reputational risk.
Such other group entity could be a subsidiary of the bank, with the potential of
downstream risk, or parent of the bank or affiliate under the control of parent i.e.
upstream risk.
•
A Bank or DFI, together with other group entities under its control, could take
exposures on a single borrower, borrowing group, or sector that are beyond
prudential limits. Generally, on individual basis, there are per party exposure limits.
However, various entities in a group may end up with an unusually large exposure
on a collective basis. Moreover, since the entities within a group may be subject to
different regulations, this may lead to regulatory arbitrage allowing banks to take
advantage of the less stringent regulatory regime applicable on some of its
subsidiaries. There might be specific intra-group linkages that could nullify the
impact of conventional risk mitigation techniques at the group level by simply shifting
the risk from one of the group entities to another.
•
Another problem is the overstatement of capital or double gearing whereby the
capital of one entity is used to satisfy the requirements of more than one affiliate
entities. This phenomenon is typical where investments are made by the parent
body in its subsidiaries. Double gearing results in the overstatement of capital and
can also lead to regulatory arbitrage.
•
Another aspect which is often difficult to detect is of intra group transactions,
which might not be on arms-length basis. This increases the likelihood of fraud or
siphoning-off of funds.
•
Liquidity risk arising from asset liability mismatch is also of great significance.
Universal banking, since it houses diverse products with different asset liability
structures and risk profiles, can be considered the most risky. In conventional
banking, where universal banking is allowed, banks need to create firewalls so that
no asset liability mismatches occur, and internal transfers of funds raised from one
type of liability (i.e. short term deposits) are not deployed against a source which
typically provides products with long term maturity (i.e. investment banking,
insurance etc).
•
In the absence of a formal Holding Company structure, the corporate structures at
the group level are quite opaque and in various cases create ambiguities about the
roles and responsibilities of the board of one entity vis-à-vis another. Similarly,
interference in the managerial functions of one entity by the officials of another has
also been witnessed. Increasing complexities in the ownership and managerial
structure of a group can make the supervision of financial institutions in the group
difficult.
•
In view of the dynamic ownership structure of our banking industry, entry of foreign
players in our market and investment by our banks abroad, it is necessary to take a
holistic view and work towards an appropriate supervisory structure (consolidated
supervision) to avoid any problem in future.
Changes sought in the legal framework and supervisory regime
These concerns and the risks associated with group relations warrant a comprehensive
framework for supervision that evaluates the strength of an entire group, taking into account
all the risks which may affect a bank/DFI, regardless of whether these risks are carried in the
books of the bank/DFI or related entities. SBP firmly believes that the financial sector as a
whole has a lot to gain through increased integration and conglomeration. However, the
newly emerging phenomenon has to be properly monitored and governed under an
appropriate legal framework to mitigate the potential risks. Keeping these factors in mind,
three major changes are being proposed in the BCO.
the current supervisory set up has to be changed to bring under the fold of SBP, all
Firstly,
deposit-taking Non Bank Financial Companies (NBFCs). The major rationale for this
proposal is that these NBFCs are engaged in activities which are quite incidental to banking,
both on the liability as well as the asset side. Bringing such entities under SBP would lead to
greater supervisory efficiency, as being the regulator of banks, its supervisory approach is
well equipped for their kind of business and the resulting risk profile. In this regard, the BCO
ought to bring under its folds, besides banks and DFIs, NBFCs like Investment Banks,
Leasing Companies, Housing Finance Companies that are until now outside its regulatory
purview.
Secondly, another change being sought is to authorize SBP to designate and regulate
financial groups. Financial group for this purpose will be any group in which at least one of
the entities is directly regulated by SBP. This is an extremely important step because it will
enable SBP to effectively monitor the potentially dubious intra group transactions involving
banks and NBFCs, and would also enable it to curtail the possible contagion risk. The
proposed amendment would also enable SBP to seek information from the unregulated
commercial entities and conduct limited inspection for verification of such information.
For entities in a financial group which fall under the purview of the securities regulator's
supervision, the current supervisory mechanism also needs to be amended to move towards
greater consolidated supervision. Under the proposed supervisory mechanism, the concept
of lead and functional supervisors has been introduced. SBP would be the Lead supervisor
for a financial group for consolidated supervision. Functional supervisor would be the
regulatory body responsible to carry out supervision of the entity on a stand-alone basis
under the relevant laws in force for the time being. In order to ensure that consolidated
supervision is done effectively, and that there are minimal enforcement issues, the power to
seek information, conduct onsite inspection in collaboration with the functional regulator,
recommend enforcement action to the functional regulator etc. are being sought for the lead
supervisor.
the time is ripe for the introduction of a Financial Holding Company (FHC) concept.
Thirdly,
SBP has so far facilitated the increasing integration of various segments of the financial
sector through various rules and regulations, and the next logical step is the creation of
enabling legal provisions for the establishment of more efficient forms of conglomerate
structures such as the FHC model. The FHC model is becoming popular in different
countries, e.g. USA, Hong Kong, Singapore, India etc.
The benefits of adopting a financial holding company model are as follows:
(i) One of the key advantages of the FHC form of structure is that it provides separation
of business activities and investment activities of financial institutions within a group.
(ii) This structure would prevent the double gearing of bank's capital and facilitate the
growth of the financial sector, as new capital injection would be required for
expanding businesses.
(iii) It would be easy to establish firewalls and protect banks from risks arising out of
non-banking activities. While banks will not be able to directly benefit from any
profits of their non bank companies, the overall group will be strengthened.
(iv) The sponsor shareholding of banking as well as non banking companies will
become transparent and help SBP in ensuring that these institutions operate at
arm's length. The majority shareholding in a bank will be channeled through the
FHC, and since under the proposed amendments, FHC supervision is with SBP, the
shareholdings can be more closely monitored.
(v) The structure provides organic growth without increasing contagion risk as it is very
unlikely that the whole group will fail.
In order to facilitate the FHC model, we are also seeking several amendments in the BCO
covering its definition, licensing and supervision (which will be by SBP), capital requirement
and various other aspects. In anticipation of these legal changes, SBP is also preparing
supportive regulations to aid the effective development of financial conglomeration and their
oversight.
In conclusion, the proposed legal and regulatory changes, discussed above, to strengthen
the oversight of the financial sector, are an integral element of the Ten Year Strategy and
blueprint of financial sector reforms prepared by the central bank. Concurrently, SBP has
also launched wide ranging reforms including capital augmentation of banks, shift to
riskbased supervisory approaches, and proper implementation of Basel II. The private sector
has responded well to SBP's initiatives and a number of banks are launching work to take
benefit of the emerging legal and regulatory changes to position their financial institutions
better to compete in a more aggressive regional and global environment.