25 1977 2002
PHILIPPINE INSTITUTE FOR DEVELOPMENT STUDIES Surian sa mga Pag-aaral Pangkaunlaran ng Pilipinas
Policy Notes December 2002
Financial Services Integration and Consolidated Supervision: Some Issues to Consider for the Philippines Melanie S. Milo*
T
he literature on the Asian financial crisis typically contends that financial liberalization and the removal of obstacles to foreign borrowing by banks and the corporate sector, coupled with poor and inadequate prudential supervision, gave rise to the risk of moral hazard and the resulting financial crisis. Consequently and not surprisingly, the enhancement of prudential regulation and supervision of banks through the adoption of international standards or “best practices” was among the recommendations and prerequisites cited for the recovery particularly of the Asian crisis economies of Thailand, Indonesia and South Korea. The architecture of financial supervision and the need for change also became an important issue to be addressed (Gochoco-Bautista et al. 1999).
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Thus, South Korea consolidated all financial sector super vision under the Financial Supervisory Service in 1999. Indonesia also announced the creation of a similar consolidated financial sector regulator in 1999, but its target date of operation has been moved from December 2002 to January 2004. Finally, Thailand drafted a Financial Institution Act that would make the Bank of Thailand solely responsible for super vising financial institutions. Developing regulator y capacity was the priority, and the reform of the regulator y structure was deemed as necessary to achieve that. There was also a need to eliminate gaps in regulatory coverage, which was a contributing factor to the financial crisis. In contrast, the Philippines did not undertake any reform of its financial sector regulatory structure. An important bill that was passed in the aftermath of the Asian crisis was the new General Banking Law of 2000 (RA 8791), an important element of which was the adoption and incorporation of internationally accepted standards and practices into the BSP’s supervisory processes. The Philippine banking sector’s regulator y framework and supervision quality already rated fairly well compared to Indonesia, South Korea and Thailand prior to the crisis. This par tly accounted for the relative resilience of the Philippine financial sector, which did not experience large financial failures. Two commercial banks, however, did fail in the aftermath of the Asian crisis—Orient Bank in 1998 and Urban Bank in 2000.1 In both cases, fraud/insider abuse was the ultimate cause of failure. The case of Urban Bank is especially note-
__________ * The author is Research Fellow at the Philippine Institute for Development Studies (PIDS). 1 Two other commercial banks with links to investment houses had earlier suffered financial difficulties but were acquired by foreign bank subsidiaries. The simultaneous weakening of the affiliated banks and investment houses was clearly interlinked. This was similar to the bank failures due to the collapse of their affiliated investment houses that occurred in the 1970s.
PIDS Policy Notes are observations/analyses written by PIDS researchers on certain policy issues. The treatise is holistic in approach and aims to provide useful inputs for decisionmaking. This Notes is based on PIDS Discussion Paper Series No. 2002-22 of the same title and author. The views expressed are those of the author and do not necessarily reflect those of PIDS or any of the study's sponsors.
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worthy because its failure had been attributed to problems in its investment house subsidiary, Urbancorp Investments, Inc. Failure to detect problems in Urbancorp, in turn, was attributed to a lapse in the supervision/regulatory oversight, arising from a confusion in the proper assignment of regulator y function over investment houses between the Bangko Sentral ng Pilipinas (BSP) and the Securities and Exchange Commission (SEC).2 Thus, what the crisis also highlighted was the need to close regulatory gaps resulting from the integrated or conglomerated nature of financial institutions framed against a fragmented regulatory system in the Philippines.
Financial services integration in the Philippines Financial services integration has long been a feature of the financial landscape in many developed countries. More recently, there has also been a trend toward a universal banking paradigm in many emerging markets. The common issue facing regulators is how best to respond to financial services integration. In par ticular, the emergence of financial conglomerates adds at least two new dimensions to the super vision and regulation of such entities in emerging markets: one is the issue of consolidated supervision, and the other is the architecture of the institutions in charge of supervision (IMF 2001). If financial sectors are integrating, should regulators do the same? To be effective, Abrams and Taylor (2000) contend that the structure of the regulator y system must reflect the structure of the markets being regulated. In contrast to other developing countries, financial services integration has been a key feature of the Philippine financial system. In the 1960s and the 1970s, integration was driven largely by regulatory arbitrage as banks and other financial institutions innovated to circumvent regulatory requirements, taxation and other restrictions, par ticularly on ____________ 2
While the New Central Bank Act of 1993 provided for the transfer of regulatory powers over finance companies without quasi-banking functions and other institutions performing similar functions from the BSP to the SEC within five years from the effectivity of the Act (Sec. 130), and gave the authority to the BSP to supervise and examine banks’ subsidiaries and affiliates engaged in allied activities, said provisions were not yet operational at that time.
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Box. Definition of terms Financial services are traditionally classified into three major sectors, namely: banking, insurance and securities. Financial services integration or financial convergence refers to the production or distribution of a financial service traditionally associated with one of the three major financial sectors by service providers from another sector. Some common terms that connote financial services integration include bancassurance, universal banking and financial conglomerates. Financial services integration also occurs through the blurring of product lines because of innovation, that is, when firms in one sector create and sell products containing significant elements traditionally associated with products of another sector (Skipper 2000). Factors that promote financial services integration include regulatory arbitrage, financial liberalization and advances in ICT.
Consolidated supervision of banks is a comprehensive approach to supervising banks that conduct some of their business through their subsidiaries and affiliates. It involves evaluating the strength of the entire banking group and taking into account all the risks that may affect a bank, regardless of whether these risks are carried in the books of the bank or related entities (MacDonald 1998). Consolidated financial sector supervision involves the unifying of the regulatory agencies over the traditional financial services sectors, whether partially or fully, and their restructuring along functional lines rather than institutional lines. An Integrated Financial Sector Supervisory Agency (IFSSA) is one that is at least responsible for prudential regulation of both banks and insurance companies. The primary motivation for consolidating financial sector supervision is the trend towards financial services integration (Carmichael 2002).
traditional deposits. In the 1980s, universal banking was introduced as part of a financial reform program to promote competitive conditions and foster greater efficiency in the financial system. Banks therefore have consistently dominated the Philippine financial system, particularly the domestic universal banks. Over the years, the country continued to follow a policy of despecialization by allowing banks to widen their range of permissible activities and products. This was reinforced by the new General Banking Law (GBL) of 2000, which further increased the allowable limits on the equity investments of universal and commercial banks in financial allied and nonallied enterprises.
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A recent policy pronouncement that will further increase financial services integration in the Philippines is the introduction of cross-selling, including bancassurance, which was also provided for under the GBL. Initially, the BSP planned to allow universal and commercial banks to sell only their subsidiaries’3 financial products such as mutual funds and life insurance. The Monetary Board, however, later decided to include banks’ affiliates, which were then liberally defined as financial allied firms in which they have at least a 5-percent stake. Thus, the direction of policy has really been towards increasing financial services integration. In contrast, there has been no corresponding change in the regulatory framework until very recently. Thus, an impor tant issue that needs to be addressed is super vision and regulation in the context of financial services integration.
Financial sector regulation The integrated nature of financial institutions under a fragmented regulatory system in the Philippines is illustrated in Figure 1. In particular, with respect to supervising universal banks, the BSP has super visory authority over banks and quasibanks and their subsidiaries and affiliates engaged in allied activities. However, some of these subsidiaries and affiliates of banks (including investment houses, securities dealers and brokers, finance companies and insurance companies) are primarily regulated by the SEC and the Office of the Insurance Commission under relevant laws. Under the original setup, examination of a banking group was conducted separately and without any coordination by several departments under the Super vision and Examination Sector of the BSP and the SEC’s Capital Market Development and Regulation, according to type of financial institution. Recently, though, there have been some moves to shift to a consolidated supervision of banks. The BSP adopted some elements of consolidation of accounts of banking groups in 1998 and imposed a common cut-off date for the examination of banks and their subsidiaries and affiliates under BSP supervision. Nonetheless, what this still means is that only subsidiary/affiliate banks and quasi-banks are examined, ____________ 3 A subsidiary is defined as a firm in which a bank has at least a 51percent stake.
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not subsidiaries and affiliates that are not banks or quasibanks. The latter are only required to submit financial statements that form part of the consolidated report. Prudential regulations such as the single borrower’s limit and ceilings on DOSRI loans, meanwhile, are currently applied only on a solo basis, except for the required compliance with the risk-based capital ratio and the limit on net open foreign exchange position. The former is applied both on solo and consolidated basis while the latter is applied only on a consolidated basis. In addition, the BSP and the SEC signed a Memorandum of Understanding (MOU) in July 2002 outlining cooperative arrangements to more efficiently share supervisory responsibilities and information for those entities that fall under the jurisdiction of both agencies. In particular, the MOU gave the BSP full regulatory powers over investment houses that are subsidiaries and/or affiliates of banks. With the lifting of the limit on a universal bank’s equity investment in an insurance company in 1999 and the recent introduction of bancassurance, strong coordination and cooperation between the BSP and the Insurance Commission is also critical. It should be noted that insurance companies are excluded when computing for the consolidated risk-based capital adequacy ratio. In August 2002, the BSP announced the reorganization of its Supervision and Examination Sector. Under the new setup, there will be four departments, with each supervising a specific group of banks according to size and complexity of organizational structure. There will thus be a Banking Group Supervision Department to supervise the largest banks and their subsidiaries while other departments will focus on other large banks with less complex organizations (including some large foreign banks), mid-size banks (including some foreign bank subsidiaries) and nonbank financial institutions, and rural and microfinance banks. These actions are certainly steps in the right direction. Clearly, the BSP recognizes the need to upgrade its supervisor y capacity, given the complexity of banking groups’ organizational structure and business activities. In particular, its effor ts to move towards consolidated supervision of banking groups and a “coordinated” approach to supervis-
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December 2002
Figure 1. Supervision of a universal bank and its subsidiaries and affiliates
Philippines, there is also a need to improve regulatory capacities for nonbank financial institutions (NBFIs). The question then is—can the consolidated financial sector supervision approach help to strengthen overall regulatory capacity and ensure consistent regulation in the Philippine financial sector?
ing financial conglomerates are in line with the core principles identified by the Basle Committee on Banking Supervision (1997). However, the BSP also concedes that its current application of consolidated supervision is still rudimentar y since existing laws preclude its full implementation. Thus, it has proposed further amendments to the New Central Bank Act. Other financial legislations will also need to be amended.
Some issues to consider
The Basle Committee also noted that effective banking super vision is only part of a public infrastructure that should be well developed, including well-defined rules and adequate supervision of other financial markets and their participants. Thus, in addition to strengthening banking regulation in the
X Basically, the underlying issue is what kind of regulatory structure would minimize the chances of government failure in ameliorating market imper fections and do so efficiently (Skipper 2000). With respect to the consolidation of financial sector supervision, there is no international consensus as yet. The literature is generally cautious, espe-
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cially in the application of the approach to developing countries.
sion and regulation to ensure and enhance super visory capacity and the effectiveness of regulation.
There is consensus, however, on the key factors that need to be considered in such an assessment. In par ticular, the literature highlighted that: a) changing of the regulatory structure must be undertaken only if it will maintain and enhance supervisory capacity and effectiveness of super vision; and b) a change in the institutional structure of regulation must reflect the change in the market structure.
X With respect to the institutional structure of financial regulation and the market structure in the Philippines, clearly, the consolidated financial sector supervision approach would be appropriate for the Philippines. As such, said approach should be seriously considered.
X While the institutional framework of the Philippines’ banking sector prior to the crisis was rated fairly well in comparison to other countries in the region, there is a need to improve regulatory capacities and eliminate gaps in regulatory coverage of other financial services sectors. The different standards of regulation and supervision over NBFIs have become more problematic recently. In particular, a number of investment houses and pre-need companies under the supervision of the SEC have run into financial difficulties. As such, the SEC has also undertaken moves to tighten its regulation and super vision over these institutions. Considering the similar nature of the pre-need industry with the insurance industry, calls have been made to place the pre-need industry under the Insurance Commission. This, however, would also require the upgrading and modernization of the private insurance sector’s regulatory framework, especially with the entry of more foreign insurers and the introduction of new products that resemble bank and securities instruments. With all the regulatory changes taking place in the different financial services sectors and other reforms being proposed, there is also a need to ensure that they are consistent and deal with the issue of regulatory arbitrage. Clearly, the public requires comparable disclosure and protection for similar products. The BSP’s efforts to coordinate and cooperate with the other financial regulatory agencies should help to somewhat narrow the differences in regulatory regimes. But the process has to be institutionalized rather than just relying on MOUs and other ad hoc arrangements. As financial services integration deepens and distinctions between financial products continue to narrow, what is needed is a broader perspective on financial sector supervi-
That being said, the bigger issue would be how to undertake it. The transition from institutional regulation to functional regulation is a complex process and will take time to implement. Consolidation can be done gradually and by building on existing structures and reform initiatives. The BSP is already taking steps to move toward consolidated supervision of banking groups, including reforming its supervisory structure. Consolidated financial sector super vision can be a natural extension of that policy where it can serve as a framework within which to view or situate current financial reforms and shape/direct future regulatory reforms. It can also ser ve as a framework in strengthening regulatory capacity over NBFIs. X Whether the Philippines opts to stick with institutional regulation or move to integrated/functional regulation, someone has to have an over view of the financial sector. The question is whether this should be the BSP or another agency. The 1987 Constitution expressly assigns the super vision of banks to the BSP. As such, it will expectedly continue to play a major, if not dominant, role in financial sector supervision. Under the New Central Bank Act, the BSP has, to some extent, become the de facto “super-regulator” of the financial system, with its authority to super vise and examine banks’ subsidiaries and affiliates engaged in allied activities. Designating the BSP as the “lead regulator” makes sense because of the dominance of banks in the financial system. Another advantage of the BSP is that it is the most experienced regulator in the financial sector, especially in a deregulated environment. It could then set the standard for the other regulators in the sector. One option would be to follow the Finland model and set up a Financial Super vision Authority attached to the BSP. The regulatory framework can be separated and transferred to the BSP, and the SEC and the Insurance Commission can then focus on the day-to-day
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regulation and supervision of the financial institutions and markets under their jurisdiction. Alternatively, as an interim measure or option, the Philippines can set up a council similar to the Federal Financial Institutions Examination Council of the US, composed of the heads of the various regulatory agencies, to promote consistency in the examination and supervision of financial institutions. Its primar y assignment was to establish uniform principles and standards and report forms for the examination of financial institutions. Similarly, Australia set up a Council of Financial Supervisors which focused on the regulation of financial conglomerates and promoted regular, high-level liaison among the various financial regulatory agencies. Its most significant contribution to the regulation of financial conglomerates was the development of a set of guidelines facilitating cooperation among its member financial regulators (Bain and Harper 1999). Such kind of council can lay the groundwork for consolidated financial sector supervision in the Philippines. The Philippines can also learn much from the more experienced integrated regulators in Singapore and Malaysia. X Identifying the appropriate level and form of intervention is a serious challenge to government. Regulatory efficiency factors in overall economic performance. Inefficiency results in costs to the community through higher taxes and charges, poor ser vice, uncompetitive pricing, or slower economic growth. In order to control costs and ensure effectiveness, regulation has to be placed within a consistent framework. To do this, it is necessar y to establish clearly what needs to be regulated and why, as well as to define the principles for effective and efficient regulation (Wallis et al. 1997). Corollary to this would be the identification of the appropriate regulatory structure. The system of supervision and regulation must, however, keep pace with a dynamic financial services industry. This is especially true given the rapidly changing financial services industry, as a result of domestic financial deregulation and external liberalization measures, and significant advances in information and communication technology. Increasing financial services integration means moving towards integrated financial ser vices regulation is warranted.
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December 2002
References Abrams, R. and M. Taylor. 2000. Issues in the unification of financial sector supervision. IMF Working Paper WP/00/213. Washington, D.C.: International Monetary Fund. Bain, E. and I. Harper. 1999. Integration of financial services: evidence from Australia. Paper presented at the Bowles Symposium, 9-10 December, Georgia State University, Atlanta. Basle Committee on Banking Supervision. 1997. Core principles for effective banking supervision. Basle: Bank for International Settlements. Carmichael, J. 2002. Experiences with integrated regulation. Paper presented at the Finance Forum 2002, 19-21 June, World Bank Institute, Washington, D.C. Gochoco-Bautista, M., S. Oh and S. Rhee. 1999. In the eye of the Asian financial maelstrom: banking sector reforms in the Asia-Pacific region. In Rising to the challenge in Asia: a study of financial markets Vol. 1. Asian Development Bank. International Monetary Fund. 2001. International capital markets: developments, prospects, and key policy issues. Washington, D.C.: International Monetary Fund. MacDonald, R. 1998. Consolidated supervision of banks. Handbooks in central banking No. 15. London: Centre for Central Banking Studies, Bank of London. Skipper, H. 2000. Financial services integration worldwide: promises and pitfalls. Organization for Economic Cooperation and Development. Wallis, S., B. Beerworth, J. Carmichael, I. Harper and L. Nicholls. 1997. Financial system inquiry final report. Commonwealth of Australia, Canberra.
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