Chapter 6 Assessing the Supervision of 6 Other Financial Intermediaries 6.1 Overview This chapter focuses on issues in the regulation of a range of non-bank financial institu tions (NBFIs),categorized as Other Financial Intermediaries (OFIs).OFIs refer to those financial corporations that are primarily engaged in financial intermediation-that is, corporations that channel funds from lenders to borrowers through their own account or in auxiliary financial activities that are closely related to financial intermediationbut are not classified as deposit takers (IMF 2004a).OFIs include insurance corporations pension funds;securities dealers;investment funds;finance,leasing,and factoring com- panies;and asset management companies.This chapter discusses considerations in assess- ing the regulation and supervision of OFls(other than insurance companies and security market intermediaries)generally,with a focus on specialized finance institutions,leasing and factoring companies,and pension funds. Although OFls are often dwarfed by commercial banks in terms of volume of business and size of assets,OFIs should receive adequate attention during the assessment process for various reasons.OFIs play an important developmental role through their activity in areas and mark he presence of commercial banks isnot fully felt.Moreover,th development of OFIs could increase bank competition,which could lead to greater access to finance.In many countries,pension funds are major contractual savings institutions with a significant effect on financial markets and the macroeconomy. Specialized financial institutions (such as thrifts,building societies,and mortgag institutions)have emerged in many countries to carry out real estate finance.However,in many countries,other than their specialization in housing finance,those institutions are
171 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 6.1 Overview This chapter focuses on issues in the regulation of a range of non-bank financial institutions (NBFIs), categorized as Other Financial Intermediaries (OFIs). OFIs refer to those financial corporations that are primarily engaged in financial intermediation—that is, corporations that channel funds from lenders to borrowers through their own account or in auxiliary financial activities that are closely related to financial intermediation—but are not classified as deposit takers (IMF 2004a).1 OFIs include insurance corporations; pension funds; securities dealers; investment funds; finance, leasing, and factoring companies; and asset management companies. This chapter discusses considerations in assessing the regulation and supervision of OFIs (other than insurance companies and security market intermediaries) generally, with a focus on specialized finance institutions, leasing and factoring companies, and pension funds. Although OFIs are often dwarfed by commercial banks in terms of volume of business and size of assets, OFIs should receive adequate attention during the assessment process for various reasons. OFIs play an important developmental role through their activity in areas and markets where the presence of commercial banks is not fully felt. Moreover, the development of OFIs could increase bank competition, which could lead to greater access to finance. In many countries, pension funds are major contractual savings institutions with a significant effect on financial markets and the macroeconomy. Specialized financial institutions (such as thrifts, building societies, and mortgage institutions) have emerged in many countries to carry out real estate finance. However, in many countries, other than their specialization in housing finance, those institutions are Chapter 6 Assessing the Supervision of Other Financial Intermediaries
Financial Sector Assessment:A Handbook indistinguishable from deposit-taking institutions such as banks,and they require atten tion from both the stability and the development perspectives. Leasing companies engage in relatively simple transactions where the lessee (a busi- ness owner)uses the asset (owned by the leasing company)for a fixed period of time, while making payments on a set schedule.At the end of the lease,the lessee buys the asset ing hinvmin companies can serve as a significant so ms wanting to inves inqmtand that investment ineaincompen yield attractiveretumif conditions are right. Factoring companies are financial institutions that specialize in the business of accounts receivable management.Factoring is an important source of external financing 6 for corporations and small and medium enterprises(SMEs),which receive credit based on the value of their nts eivables.Under this form of asset-based finance,the credit provided by a lender is explicitly linked ona formula basis to the value of a borrower underlying assets (working capital),not to the borrower's overall creditworthiness.In developing countries,factoring offers several advantages over other types of lending.First. factoring may be particularly useful in countries with weak secured-lending laws,inef- ficient bankruptcy systems,and imperfect records of upholding seniority claims,because part of the estate of a bankrupt SME.Second,in a factoring is arily based on 9 of the underlying isk SME ecorin may beepeciallyi ohigh- The development of Ofls such as leasing and factoring companies (especially if thev were operated by groups that were independent of large banks and insurance companies) increases lending to smaller borrowers.Some practitioners argue that stand-alone OFIs tend to compere more vigorously.for that r onal Finance Corporation prefers ance asing con despit their disadv antage wher compe can tap into low-cost depositors funding from their parent companies)(International Finance Corporation 1996). While the small size of the OFI sector in some countries may limit OFI's systemic effect on the rest of the financial sector in case of crisis,stress in OFIs could have systemic effects in specific circumstances.In particular,difficulties in OFls may have some systemic effect,insc ey trigger a loss onfidence in dep ect of the financial systemt effective regulations for OFIs can exacerbate the fragility of the overall financial system through regulatory arbitrage(Herring and Santomero 1999). In many countries,pension funds are a major source of contractual savings,providing a stable source of long-term investment to support growth and at the same time playing a key role in financial markets through their nent behavior.National pension tems provide retirement in ome from a mixture of govern emplo vidual savings.Pension funds affect the stability of financial markets and the distribution of risks among different sectors of the economy by their investment behavior and the way they manage their risk. 172
172 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 indistinguishable from deposit-taking institutions such as banks, and they require attention from both the stability and the development perspectives. Leasing companies engage in relatively simple transactions where the lessee (a business owner) uses the asset (owned by the leasing company) for a fixed period of time, while making payments on a set schedule. At the end of the lease, the lessee buys the asset for a nominal fee, giving the lessee the opportunity to make a capital investment. Leasing companies can serve as a significant source of finance for small firms wanting to invest in equipment, and that investment in leasing companies can yield attractive returns if conditions are right. Factoring companies are financial institutions that specialize in the business of accounts receivable management. Factoring is an important source of external financing for corporations and small and medium enterprises (SMEs), which receive credit based on the value of their accounts receivables. Under this form of asset-based finance, the credit provided by a lender is explicitly linked on a formula basis to the value of a borrower’s underlying assets (working capital), not to the borrower’s overall creditworthiness. In developing countries, factoring offers several advantages over other types of lending. First, factoring may be particularly useful in countries with weak secured-lending laws, inefficient bankruptcy systems, and imperfect records of upholding seniority claims, because factored receivables are not part of the estate of a bankrupt SME. Second, in a factoring relationship the credit is primarily based on quality of the underlying accounts, not on the quality of the borrower. Thus, factoring may be especially attractive to high-risk SMEs (Bakker, Klapper, and Udell 2004). The development of OFIs such as leasing and factoring companies (especially if they were operated by groups that were independent of large banks and insurance companies) increases lending to smaller borrowers. Some practitioners argue that stand-alone OFIs tend to compete more vigorously. For that reason, the International Finance Corporation prefers to finance stand-alone leasing companies despite their disadvantage when competing with leasing subsidiaries of commercial banks, which can tap into low-cost depositors’ funding from their parent companies) (International Finance Corporation 1996). While the small size of the OFI sector in some countries may limit OFI’s systemic effect on the rest of the financial sector in case of crisis, stress in OFIs could have systemic effects in specific circumstances. In particular, difficulties in OFIs may have some systemic effect, insofar as they trigger a loss of confidence in deposit-taking activities. For instance, a crisis of confidence can spread from one subsector of the financial system to another subsector, owing to perceived ownership or balance-sheet linkages. Moreover, the lack of effective regulations for OFIs can exacerbate the fragility of the overall financial system through regulatory arbitrage (Herring and Santomero 1999). In many countries, pension funds are a major source of contractual savings, providing a stable source of long-term investment to support growth and at the same time playing a key role in financial markets through their investment behavior. National pension systems provide retirement income from a mixture of government, employment, and individual savings. Pension funds affect the stability of financial markets and the distribution of risks among different sectors of the economy by their investment behavior and the way they manage their risk
Chapter 6:Assessing the Supervision of Other Financial Intermediaries 6.2 Objectives of the Legal and Regulatory Framework for OFls? Against this background,the assessment of the regulation and supervision of OFIs should not only account for their effectiveness in meeting the traditional obiectives of financial supervision,but should also consider whether the regulatory framework helps build a sound environment that fosters the development of those institutions.For instance,an regulatory fra ork that pro rage in the OFI se could restrict the potential developmental role of OFIs and at the same time could lea to the buildup of substantial undetected vulnerabilities and risks While both competition regulation and conduct of business (including market integri- ty)regulation apply to all sectors and institutions in the financial system,assessing which type of OFIs nts prudential regulation is,in practice,a difficult exercise.Three char 6 acteristics an cial ritical nj ing the scope ntia on:the dificulty of honoring the contracttions (b)the dcutyaced the consumer in assessing the creditworthiness or soundness of the institution,and (c)the adversity caused by a breach of contractual obligations(see Carmichael and Pomerleano 2002).For instance,banks are subject to systemic liquidity risks that may lead to the breach of obligations,financial have c mplex s es whose soundnes and creditworthiness are difficult to assess,and the failure of a large bank or company is likely to generate great adversity.Each group of institutions could be ranked using those characteristics to judge the desirability and scope of prudential oversight. An appropriate regulatory environment is required to foster the development of OFIs as recognized legal e ities that are well integrated with the rest of the financial system In ma es,the legal and regulatory fra work for finance,leas and other specialized financial institutions is ambiguous,fragmented,and incomplet Assembling and analyzing the laws and regulations governing the operations of each group of institutions to ensure clarity and completeness is an important step in the assess. ment of OFIs.While repressive regulation can retard the growth of OFIs,an inappropriate and poorly designed r ulatory structure can create incentives for regulatory arbit age However,even hen high-quality l tion exists,enforcement is sometimes poo I hose factors are all impediments to the development of the financial system in general but the impediments become more pronounced in the case of OFls that,in many emerg- ing economies,are often not supported by a clear legal framework. Legislation should permit effective enforcement.The legal framework for financial supervision could be so ewhat prescriptiv spelling specific prudential rules of the governing law,or could be general,th hereby providi ing guideline and principles while conferring broad regulatory powers on the regulator.The guidelines approach could provide more discretion and flexibility to the regulator,which may be particularly important for OFIs,because separate laws governing specific types of OFIs and markers ofe overlap,which gives ris to conficts and ambiguity regarding the onal inde er the effective use of discretion,a more-prescriptive law,if well designed,could provide a workable alternative. 173
173 Chapter 6: Assessing the Supervision of Other Financial Intermediaries 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 6.2 Objectives of the Legal and Regulatory Framework for OFIs2 Against this background, the assessment of the regulation and supervision of OFIs should not only account for their effectiveness in meeting the traditional objectives of financial supervision, but should also consider whether the regulatory framework helps build a sound environment that fosters the development of those institutions. For instance, an inadequate regulatory framework that promotes regulatory arbitrage in the OFI sector could restrict the potential developmental role of OFIs and at the same time could lead to the buildup of substantial undetected vulnerabilities and risks. While both competition regulation and conduct of business (including market integrity) regulation apply to all sectors and institutions in the financial system, assessing which type of OFIs warrants prudential regulation is, in practice, a difficult exercise. Three characteristics of financial institutions are critical in judging the scope of prudential regulation: (a) the difficulty of honoring the contractual obligations, (b) the difficulty faced by the consumer in assessing the creditworthiness or soundness of the institution, and (c) the adversity caused by a breach of contractual obligations (see Carmichael and Pomerleano 2002). For instance, banks are subject to systemic liquidity risks that may lead to the breach of obligations, financial conglomerates have complex structures whose soundness and creditworthiness are difficult to assess, and the failure of a large bank or insurance company is likely to generate great adversity. Each group of institutions could be ranked using those characteristics to judge the desirability and scope of prudential oversight. An appropriate regulatory environment is required to foster the development of OFIs as recognized legal entities that are well integrated with the rest of the financial system. In many emerging economies, the legal and regulatory framework for finance, leasing, and other specialized financial institutions is ambiguous, fragmented, and incomplete. Assembling and analyzing the laws and regulations governing the operations of each group of institutions to ensure clarity and completeness is an important step in the assessment of OFIs. While repressive regulation can retard the growth of OFIs, an inappropriate and poorly designed regulatory structure can create incentives for regulatory arbitrage. However, even when high-quality legislation exists, enforcement is sometimes poor. Those factors are all impediments to the development of the financial system in general, but the impediments become more pronounced in the case of OFIs that, in many emerging economies, are often not supported by a clear legal framework. Legislation should permit effective enforcement. The legal framework for financial system supervision could be somewhat prescriptive, spelling out specific prudential rules within the scope of the governing law, or could be general, thereby providing guidelines and principles while conferring broad regulatory powers on the regulator. The guidelines approach could provide more discretion and flexibility to the regulator, which may be particularly important for OFIs, because separate laws governing specific types of OFIs and markets often overlap, which gives rise to conflicts and ambiguity regarding the applicable rules. If, however, the regulator’s lack of operational independence hampers the effective use of discretion, a more-prescriptive law, if well designed, could provide a workable alternative
Financial Sector Assessment:A Handbook 6.3 Assessing Institutional Structure and Regulatory Arbitrage The appropriateness of the institutional structure for supervising OFIs should conside the overall institutional framework for financial supervision and the scope of the OFIs' activities within that framework.The number and size of OFIs(individual and aggregate), as well as their links to banks and other players in the financial system,are major fac tors infuepcing the appropriate institutional structure for superyising Fls.The stage of financial develor nvironn ent gen and the e of re efor supervising cused on the natur 6 An institutional structure that is sectorally focused rather than fo of functions to be regulated may result in gaps in the regulation of OFIs.In some country circumstances,therefore,bringing the regulation and supervision of all types of financial institutions,including OFIs,under a unified supervisory framework would help reduce the possibilities of regulatory arbitrage and regulatory gaps and allow for more-efficient oversight.A unified structure facilitates the adoption of a common set of standards for institutions with the same of bus profile of risk-for instance,uniform application of conduc ssand financial in gulations, and adi lations ents in th cope of prudential H ever nder structur it an on Ekmocdmfgaoaoadp ory body inv n institu regulation and supervis al atter tion of conflicting areas of jurisdiction,and the extent of regulatory duplication.This sectorally focused structure is a source of inconsistencies and ambiguities that have cre ated weaknesses in the regulatory and supervisory process in many countries.For instance, this structure's inability to undertake"fit-and-proper"tests and impose minimum capital requirements or other specific guidelines creates loose regulatory and supervisory regimes that allow OFIs to develop their business recklessly and get involved in banking activi tie In co separate,se torally focu regulators,the ass ment should focu on ver s of servic providers,since the application of different rules to products and services that are fund tionally equivalent can give rise to increased incentives for regulatory arbitrage (OECD 2002).For instance,institutions assuming the main banking functions should be con- sidered banks and regulated and supervised as such.In some countries.Ofls became an important segment of the financial system as a result of efforts to circumvent prudential norms and exploit loopholes in the banking sector Table 6.1 compares the regulatory featu res of banks and OFIs.Raising the following que stions whe comple table 6 1 ca help regulat i近the dif ces in the rules applied to different group of institutions (Carmichael and Pomerleano 2002) tors by altering its corporation form,regulatory jurisdiction,or institutional label?For example,is a parent institution able to reduce its regulatory burden by shifting business into an unregulated subsidiary? 174
174 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 6.3 Assessing Institutional Structure and Regulatory Arbitrage The appropriateness of the institutional structure for supervising OFIs should consider the overall institutional framework for financial supervision and the scope of the OFIs’ activities within that framework. The number and size of OFIs (individual and aggregate), as well as their links to banks and other players in the financial system, are major factors influencing the appropriate institutional structure for supervising OFIs. The stage of financial development, the legislative environment generally, and the range of regulators’ skills available would also affect the appropriate institutional structure for supervising OFIs. An institutional structure that is sectorally focused rather than focused on the nature of functions to be regulated may result in gaps in the regulation of OFIs. In some country circumstances, therefore, bringing the regulation and supervision of all types of financial institutions, including OFIs, under a unified supervisory framework would help reduce the possibilities of regulatory arbitrage and regulatory gaps and allow for more-efficient oversight. A unified structure facilitates the adoption of a common set of standards for institutions with the same profile of risk—for instance, uniform application of conduct of business and financial integrity regulations, and adjustments in the scope of prudential regulations according to risk profile. However, under a structure with more than one regulatory body involved in institutional regulation and supervision, special attention should be given to the definition of the legal power of responsible bodies, the identification of conflicting areas of jurisdiction, and the extent of regulatory duplication. This sectorally focused structure is a source of inconsistencies and ambiguities that have created weaknesses in the regulatory and supervisory process in many countries. For instance, this structure’s inability to undertake “fit-and-proper” tests and impose minimum capital requirements or other specific guidelines creates loose regulatory and supervisory regimes that allow OFIs to develop their business recklessly and get involved in banking activities. In countries with separate, sectorally focused regulators, the assessment should focus on verifying the differences in the types of risk posed by various categories of service providers, since the application of different rules to products and services that are functionally equivalent can give rise to increased incentives for regulatory arbitrage (OECD 2002). For instance, institutions assuming the main banking functions should be considered banks and regulated and supervised as such. In some countries, OFIs became an important segment of the financial system as a result of efforts to circumvent prudential norms and exploit loopholes in the banking sector. Table 6.1 compares the regulatory features of banks and OFIs. Raising the following four questions when completing table 6.1 can help regulators verify the differences in the rules applied to different group of institutions (Carmichael and Pomerleano 2002): • Can institutions subjected to different regulation provide similar products? • Is a financial institution capable of choosing among different regulators by altering its corporation form, regulatory jurisdiction, or institutional label? For example, is a parent institution able to reduce its regulatory burden by shifting business into an unregulated subsidiary?
Chapter 6:Assessing the Supervision of Other Financial Intermediaries Table 6.1.Main Requlatory and Prudential Aspects of Different Groups of Financial Institutions' Commercial Non-deposit-taking Regulation banks Deposit-taking institutions Main regulator/superviso Restriction on loans Participation in the clearing/settlement system lesulna deoosits Minimum risk weighted capital/asset ratio Liquidity ratio 6 Cash reserve requirements Required provis Limit to a sinale borrower Insider lendinn .Can new OFIs offer banking-type products under a different banner to remain a regulat bility for financial conglomerates? In a unified supervisory structure where the number of OFls is significant but OFl operate independently from the main players in the financial sector (i.e.,banks and insurance companies),establishing a separate department that is exclusively dedicated to the supervision of OFls is a common practice.In such structure,there are cases where the same s are responsible for both onsit supervision and offsit pe vision for a group of OFIs,or cases where there is separation between the responsibility for onsit and offsite functions.On the one hand,having the same regulators be responsible for both onsite and offsite functions helps ensure continuity in monitoring events in the sector,as well as coherence in supervision.On the other hand,separating offsite and onsite func. tions provides a certain degree of specialization in the related pr cesses and procedures.In either case. the skill leve toavoid having inexperien and unqual d regulators ally assigned to supervising OFIs In a unified structure where the links between OFIs and banks are significant through investment and ownership,regulators with responsibility for a group of related institu- tions (including banks and OFls)help monitor development in related sectors in a con solidated manner.Moreover,specialization helps enhance the regulation and supervision of OFIs.Regulators in cha rge o f supervising b they receive adequate training and guidance to specifically deal with OFls.As stresed in the Basel Core Principles(BCPs)for Effective Banking Supervision,an essential element 175
175 Chapter 6: Assessing the Supervision of Other Financial Intermediaries 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 • Can new OFIs offer banking-type products under a different banner to remain outside the jurisdiction of the main regulator? • Is there a regulatory structure in which at least one regulator has overall responsibility for financial conglomerates? In a unified supervisory structure where the number of OFIs is significant but OFIs operate independently from the main players in the financial sector (i.e., banks and insurance companies), establishing a separate department that is exclusively dedicated to the supervision of OFIs is a common practice. In such structure, there are cases where the same regulators are responsible for both onsite supervision and offsite supervision for a group of OFIs, or cases where there is separation between the responsibility for onsite and offsite functions. On the one hand, having the same regulators be responsible for both onsite and offsite functions helps ensure continuity in monitoring events in the sector, as well as coherence in supervision. On the other hand, separating offsite and onsite functions provides a certain degree of specialization in the related processes and procedures. In either case, the regulators’ skill levels should be adequate to avoid having inexperienced and unqualified regulators be systematically assigned to supervising OFIs. In a unified structure where the links between OFIs and banks are significant through investment and ownership, regulators with responsibility for a group of related institutions (including banks and OFIs) help monitor development in related sectors in a consolidated manner. Moreover, specialization helps enhance the regulation and supervision of OFIs. Regulators in charge of supervising banks can usually supervise OFIs, provided they receive adequate training and guidance to specifically deal with OFIs. As stressed in the Basel Core Principles (BCPs) for Effective Banking Supervision, an essential element Table 6.1. Main Regulatory and Prudential Aspects of Different Groups of Financial Institutionsa Regulation Commercial banks Deposit-taking institutions Non-deposit-taking institutions Main regulator/supervisor Restriction on loans Participation in the clearing/settlement system Issuing deposits Subject to onsite supervision Subject to offsite supervision Minimum paid-up capital Minimum risk weighted capital/asset ratio Liquidity ratio Cash reserve requirements Required provisions Limit to a single borrower Insider lending a. This table can be adapted to individual country situations