Searching for New Regulatory Frameworks for the Intermediate Financial Structure in Post-Crisis Asia
Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania
Intermediate Financial Structure
1. In a number of Asian countries, commercial banks are already playing an important role in the corporate bond market as issuers, underwriters, investors, and guarantors. This reflects banks’ already dominant financial positions in their financial markets, good reputation, and informational advantages. Thus, the role of banks for fostering the development of the corporate bond market and their complementary roles should be encouraged.
2. This financial landscape is referred to as the “intermediate financial structure” where bank loans are substituted for premature corporate bonds. This structure lies between a bank-dominated financial structure where banks provide traditional banking services by taking public liquid saving and financing business investment on the one hand, and a fully-fledged capital market-based financial structure where a large number of borrowers have direct access to corporate bond and there are numerous, d iversified investors that are willing to diversify their asset portfolios on the other hand. In the latter case, corporate bonds substitute for bank loans extended to large, reputable corporations.
3. In the intermediate financial structure, so-called “long-term credit banks” may issue relatively medium-term bank debenture (i.e. 1-5 years). This may be desirable especially when the country has a sufficiently high rate of savings, yet investors in those countries are reluctant to diversify their portfolios given their strong preference for safe, liquid bank deposits. These banks may play the role of transforming short- and medium-term funds to long-term funds that were in high demand by the private sector investment projects if such medium-term bank debentures are bought by relatively wealthy individuals, small deposit -taking commercial banks, credit unions, etc. for their portfolio
4. Initially, it may be desirable for the central bank to indirectly support bank debentures by using them in open market operations or qualifying them for central bank discount window, in order to increase liquidity and investors’ confidence in bank debentures. This support system may make bank debentures an attractive payment reserve assets for commercial banks, which perennially depend on central bank borrowings. It should be pointed out that long-term credit banks played a crucial role in Japan in terms of shifting the industrial structure from light to heavy industries by providing careful screening of new, venture-style industries and making bold investments based on their demand forecasts during the high growth period. However, this period coincided with the period of the low -interest policy including bank debentures and thus it may be still debatable whether long-term credit banks can be developed, at least initially, without such a financial restraint policy. Also, cofinancing with commercial banks can be used to enhance discipline on management of these banks.
5. Banks’ involvement in securities activities give rise to various advantages to the banking sector, borrowing firms, and economy. First, in recent years, banks have been increasingly experiencing a decline in their incomes from traditional banking services in the process of domestic banking sector liberalization and capital account liberalization. As a result, banks find it difficult to sustain their profitability and acquire implicit rents, which enable them to offer discretionary, repetitive, and flexible banking services to their borrowers and form long-term relationships with them. Therefore, if banks are able to maintain long-term relationships with their clients throughout the latter ’s life cycles—starting with bank loans and later switching to securities underwriting, banks will be encouraged to spend more resources in generating inside information about their clients and prudently monitoring their performance. Furthermore, the diversification of banks’ asset portfolios helps lower banks costs of funds, which reduces the costs that banks charge their lending and underwriting customers.
6. Second, banks are able to perform securities activities more efficiently than nonbank financial institutions thanks to their good reputation and informational advantages. Good reputation improves investor confidence and thus encourages investors to purchase securities underwritten by banks. Furthermore, since banks already possess inside information about their clients through relationship lending, they do not need to spend a lot of resources in order to underwrite securities , and thus their underwriting costs can be lower than those of nonbank underwriters. This advantage is strengthened further since banks can utilize their blanch networks and staff in order to conduct securities businesses. A lower underwriting cost would promote firms’ investment growth and high economic growth.
7. Third, banks’ engagement in securities businesses may promote mergers and conglomeration of the banking sector, thereby improving operational efficiency. Fourth, the development of long-term credit banks may contribute to reducing a maturity mismatch and facilitating the development of domestic corporate bond markets by promoting long-term lending to the private sector.
8. On the other hand, banks’ engagement in securities businesses may give rise to disadvantage to the baking sector, ultimate borrowers, and investors. First, banks may end up lending to small firms if large, reputable firms increasingly raise funds through issuing securities. This tendency is more pronounced for small banks if large banks increase their lending and securities businesses with large clients. This suggests that banks face a higher default ratio on the average bank credits, strengthening the need to improve their internal risk management system. Second, financial conglomeration may crowd out small firms because it may encourage banks to shift toward megabanks through acquiring smaller, weaker banks in order to exploit economies of scope and diversification benefits. As a result, the number of small banks would be smaller and thus, small firms may find it more difficult to obtain funds from banks. Third, as the size of banks becomes larger through financial conglomeration, concentration of power in the banking sector may occur. This may deter the development of capital markets since banks tend to place priority on lending businesses over securities businesses and tend be reluctant to initiate financial innovation.
9. Fourth, conflicts of interest between banks and investors may emerge, as exemplified by the case that banks attempt to underwrite securities of troubled borrowers where the proceeds of the issues are used to pay off banks’ own loans to the firms. The presence of such conflicts may weaken investor confidence in the capital market and thus discourage the market to develop further. Fifth, issuers may find it difficult to switch from bank underwriters to independent underwriters when they have already formed long-term banking relationships with the former, resulting in high switching costs. If public investors cannot trust independent underwriters, they would discount the value of corporate bonds underwritten by even honest underwriters.
10. Sixth, when banks engage in large-scale securities and derivatives activities as dealers and/or end users, banks bear various risks—such as the risk of buying up unsold securities underwritten by them, counterparty risk, market risk and etc. Thus, the failure of these businesses may weaken solvency of these banks and trigger systemic banking crises. In particular, derivatives activities are generally conducted by a limited number of large banks, making a systemic banking crisis a plausible outcome. Furthermore, derivatives activities may lower trans parency by increasing the speed and complexity of transactions. Thus, the regulator may find it more and more difficult to contain risks associated with derivatives transactions because of the extreme difficulty in understanding the nature and risk and closely and promptly collaborating across nations.
11. Therefore, in searching for appropriate regulatory frameworks for the intermediate financial structure, the advantages and disadvantages described above should be carefully examined and regulatory frameworks should take into account those tradeoffs. In other words, regulatory frameworks for the intermediate financial structure should include (1) a further strengthening of the banking sector, (2) measures to contain disadvantages arising from banks’ engagement in securities businesses, (3) measures to cope with problems associated with derivatives activities, and (4) coordination issues among relevant regulators.
Strengthening the Banking Sector in Asia
12. First of all, priority should be placed on strengthening of the banking sector even more seriously than ever. First, banks may face new risks or amplified risks as a result of their engagement in securities and derivatives activities. Second, banks are likely to face a higher default ratio on their average bank credit since large, reputable firms increasingly issue securities and thus only small firms without such access depend solely on bank loans.
13. How should we strengthen the banking sector? In the case of Asia, three separate steps are required to be taken. The first step is to remove government intervention both in directing private bank credit to special industries and/or companies selected by the government and in bailing out any banks in distress regardless of their viability. Such intervention discourages banks’ incentives to conduct risk management based on processing idiosyncratic information about their clients and prudently monitoring borrowers’ performance.
14. The second step is to limit banks ’ lending in favorable terms to firms that are connected to each other through holdings of shares—connected lending. In general, the ownership of Asian firms is highly concentrated through family controls and group affiliations, which generates a divergence between cash-flow rights and control rights. Even if control rights of each firm based on the share of stock holding is small, ownership based on voting rights, not cash-flow rights, can be concentrated through pyramid structures —where a firm owns a majority of the stock of one firm, which in turn holds a majority of the stock of another firm and this process can be repeated several times.
15. Banks are often incorporated in this pyramid structure, providing loans to affiliated firms without properly taking into account risks involved. Therefore, it is also important to limit banks’ holdings of equity issued by nonbank firms until banks improve their internal risk management systems. At the same time, special attention should be paid to the quality of banks’ own capital, since banks’ shareholders–often concentrated—may constitute largely banks’ borrowers or may raise funds for purchasing banks ’ shares from unregulated financial companies. In such cases, banks ’ capital requirement should be raised further until banks’ management becomes clear ly separated from their ownerships.
16. Once government intervention and connected lending are reduced, the third step is to adopt prudential regulations and supervision similar to those in industrial countries. This sequence is important because until the first two steps are undertaken, the soundness of the banking system would not improve meaningfully even though sophisticated prudential regulations are introduced. Traditional indicators frequently used in industrial countries to estimate the soundness of banks include capital adequacy ratios, liquidity ratios, and non- performing loan ratios. However, these indicators are not necessarily effective in Asia. This is because (1) the poor accounting, auditing, disclosure requirements, (2) the concentrated ownership of bank equity and subordinated debt by large family businesses, as discussed above and, (3) illiquid secondary markets of their own capital. Therefore, prudential regulations and supervision should be supplemented with the use of market-related indicators in addition to traditional indicators if the soundness of Asian banks is to be evaluated in a more realistic manner.
17. The market-related indicators include (i) deposit rates, (ii) interest rate spreads of banks, (iii) interbank rates, etc. The first two indicators are useful, because low interest rate spreads and high deposit rates indicate the weakening performance of banks. This is because poorly-managed banks attempt to increase their market share by rapidly expanding their loan portfolio through loans to risky borrowers and to gain funding by raising deposit rates. Since these banks do not increase lending rates because they know that this could cause their risky borrowers to default, their interest rate spreads decline. The third indicator is also useful, since banks may know financial positions of other banks much better than depositors or bank shareholders through conducting financial transactions with each other in interbank markets.
Containing Disadvantages of Banks’ Engagement in Securities Businesses
18. How can various disadvantages arising from banks ’ engagement in securities businesses be mitigated? What organizational form should be selected? One needs to examine whether the disadvantages could be contained under the banking organization where banks directly engage in securities activities. Alternatively, the disadvantages should be mitigated by separating securities activities from banking activities through establishing legally separated subsidiaries. The former refers to the universal banking form of baking organization. The latter is divided further into two forms: (1) banks with their own subsidiaries (“bank subsidiary form”) and (2) bank holding companies under which securities subsidiaries operate (“BHC form”).
19. The universal banking form assumes that the regulator is able to contain various problems associated with securities services either by combining all activities within the banking entity and pooling risks with a common capital adequacy requirement to the combined businesses, or defining banking and securities activities and applying differential capital requirements on them based on definitions. The latter require banks to set higher capital adequacy requirements on banking services than securities services because banks are exposed to liquidity and systemic risks. The latter includes a trading book approach adopted in the European Union, which segregates securities trading book from the rest of businesses and makes trading book alone be subject to different capital requirements.
20. In practice, however, such approaches may be difficult to implement. First, the approaches require sophisticated accounting, auditing and disclosure standards in order to mitigate disadvantages arising form banks’ engagement in securities businesses. Second, differential capital requirements among various types of services may give rise to regulatory arbitrage. Third, since banks are able to get lower funding through various safety nets than nonbank financial institutions, they may have strong incentives to engage in securities businesses more intensively. This may incur moral hazard problems, reinforcing banks’ excessive risk taking behavior. These problems are serious, particularly in Asian developing countries where regulatory capacity and expertise are too limited to cope with the variety of problems arising from banks’ engagement in securities businesses.
21. In this circumstance, it may be desirable for banks to engage in securities services at separate subsidiar ies or legally independent firms. Thus, the choice will lie between the bank subsidiary form and the BHC form, both of which separate banking businesses from securities businesses with firewall provisions.
22. In Asia, the bank subsidiar y form may be suit able for four reasons. The first reason is that banks may directly exert discipline on the management of their securities subsidiaries, while they are not able to do so under the BHC form. The second reason is that it is cheaper to establish the bank subsidiary form of banking organization than the BHC form. Third, there appears to be a natural preference to the bank subsidiary form over the BHC form in countries whose banks are free to choose any form. These factors suggest that the bank subsidiary form is superior to the BHC form. Fourth, there is no strong evidence that firewall provisions of the BHC form were effective, especially in the case when non-bank affiliates fall in financial distress. This reduces the advantage of the BHC form over the bank subsidiary form.
Managing Problems Associated with Derivatives Activities
23. Third, as derivatives businesses increase, banks —particularly large banks that originate large-scale business loans —need to enhance their internal credit rating systems. This requires highly skillful expertise and manpower as the systems involve gathering quantitative and qualitative information on highly complicated transactions, comparing the standards for each grade of these transactions, weighting these transactions in choosing a borrower grade, and supplementing this process by establishing mathematical models. Given this trend, regulators should adjust to a new environment by directing their supervisory methods towards more risk-focused monitoring than balance sheet-based monitoring. The important issues should be placed on what types of risks that banks are facing and how they manage those risks.
24. Furthermore, the regulators may be able to limit risk and problems associated with derivatives activities by encouraging transactions to be conducted at organized exchanges, or imposing margin requirements and/or increase collateral if transactions take place at over-the-counter (OTC) markets. Also, imposing limit on large-scale derivatives activities may be desirable.
Coordinating Banking and Securities Market Regulators
25. Fourth, as banks increasingly engage in securities and derivatives activities, relevant regulators need to coordinate in order to improve the effectiveness of regulation. Regulators need to examine whether they should take an umbrella approach in which banking and securities regulatory authorities are separately established and coordinated or an integrated approach in which all relevant regulators are integrated under the uniform authority. It may be desirable for Asian developing countries to select an umbrella approach since they have not sufficiently strengthened prudential regulations and supervisions in the banking sector. In this circumstance, the integration of a bank regulator with other nonbanking regulators may lower confidence in the overall financial system, since such an integration may weaken regulatory capacities of the banking regulator given limited human and financial resources. Furthermore, many countries have not established independence of regulatory regimes including central banks from policy intervention. Thus, the integration of various relevant regulators without ensuring independence may weaken the quality of the overall regulatory regime and thus its credibility. The government should place priority on promptly strengthening the bank regulation, while improving regulatory capacities for nonbanking businesses.
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