In a report on risk management and protecting depositors, the CB said that introducing legal reforms to address existing limitations relating to regulation and supervision of financial conglomerates, developing a mechanism to share information among domestic regulators as well as those in other countries (in the case of international financial conglomerates) and preparing comprehensive resolution plans for banks and other financial institutions to deal with severe financial difficulties are some of these measures.
The CB said the recent global financial crisis has emphasised the importance of managing systemic risk, which disrupts the financial system and has a significant adverse impact on the real economy.
“The interconnectedness of financial institutions has been identified as a critical source of systemic risk. Financial institutions can be connected to each other in several ways, such as by having common shareholders and directors, being subsidiaries or associates of a common parent/holding company or by making considerable investments in and/or granting loans to each other,” it said.
Increased interconnectedness of financial institutions (banks, finance companies, leasing companies, primary dealers, insurance companies, stock broking companies, unit trusts etc.) amplifies several risks that could affect the stability of the financial system as a whole. The following are among the most significant:
a) Contagion: This risk occurs when one entity’s financial difficulties adversely affect the entire group (just like what happened to the Ceylinco Group). Contagion can be due to intra-group exposures such as credit extension and intra group guarantees or commitments. Even if there is no financial exposure, news of losses or falling profits in related companies may still weaken depositors’ confidence in a financial institution and bring it under liquidity pressure.
b) Lack of transparency: Transparency means the availability of accurate, timely and relevant information about the entire group to its stakeholders. The legal and managerial structure of an entire group is crucial for regulators to identify the group as a whole to enforce regulations. Complex group structures facilitate dishonest or fraudulent personnel to hide their activities from regulators. Financial institutions may deliberately choose a complex structure to conceal their true operations or true ownership, and thereby avoid effective regulatory supervision.
c) Regulatory Arbitrage: Different financial institutions may have different regulators and may be subject to different regulatory requirements. The term “Regulatory Arbitrage” is used to refer to the shifting of certain activities or positions within a corporate group, either to avoid a situation of relatively more strict prudential supervision by one regulator compared to another, or to avoid supervision altogether (by transferring the activities or positions to a non-regulated entity).
d) Intra – group Transactions and Exposures: Intra – group Transactions and Exposures (ITEs) take the form of direct and indirect claims among entities within a group. Any material ITE could trigger resolution action or failures in group companies, which in turn could impact financial system stability.
The CB commenced a study to assess the impact of any concentration risk arising due to interconnectedness of licensed banks with other entities. Information on exposure of banks to subsidiaries, associates, other investee entities and top 20 groups/customers was collected.
There were 11 banking groups identified with 38 subsidiaries and 22 associates. Further, the banks had invested in 95 business entities other than subsidiaries and associates. The interconnection ranged from financial service providers such as insurance, investment banking, leasing and finance business, stock broking, money exchange business and unit trust management to non-financial service providers such as property development, travel related services, hotel service, venture capital financing, consultancy services and IT related services. The exposure of the banking sector to large 20 corporates was around 18 per cent of the total assets of banks while it ranged between 0.04 per cent and 78.1 per cent with respect to individual banks. However, the exposure of the banking sector to other subsidiaries and associates was only 1.4 per cent of the banks’ total assets.