SG is a business consultant specialising, inter alia, in the area of corporate finance including international finance.
Financial sector consolidation is where the banks or financial institutions in a particular financial system merge together so that only a few large financial institutions remain post merger. In other words, it is a consolidation among the financial institutions in a financial system. Financial sector consolidation could either be organic i.e. where financial institutions voluntarily merge to serve their own interest or mandated by the regulator. Either way, the consolidation expects to achieve one or more of the below mentioned objectives.
Benefits of Financial Sector Consolidation
Financial sector consolidation has been carried out in many countries, both developed and developing economies, to achieve one or more of the following objectives; increase the capital base of financial institutions; the ability for financial institutions to fund large scale projects in the economy, attract more foreign investment through financial institutions with a larger asset base, achieve synergies and increase efficiency and profitability, increase the range of financial products and services offered. While the above objectives are more related to an organic consolidation process, the overarching objective of a regulator mandated consolidation has been to address weaknesses in particular a financial institution or the system as a whole and to improve oversight over the financial system.
A good example of a country that has achieved the above objectives of consolidation is Canada. Its banking sector is concentrated among five large banks. This was highlighted as the main reason why Canada was able to avoid the devastating impact of the financial crisis in 2008. Whereas, its close neighbour the US suffered severely and witnessed the collapse of several high profile institutions, including the investment banking giant Lehman Brothers. Because of the consolidated banking sector the Canadian banks did not have to resort to any unconventional and risky business in search of profits. Whereas, the US financial institutions took the dangerous path of credit fuelled derivatives transactions to earn higher profits and this became their undoing.
Drawbacks of Financial Sector Consolidation
"Too big to fail"
When financial sector consolidation takes place a fewer number of large financial institutions remain making these institutions significant in the financial system. If one of these institutions ran into any difficulty it would create instability in the whole financial system. Therefore, once consolidation occurs the remaining few financial institutions become systemically significant and a country could not afford to have one of these institutions fail due to the repercussions on the entire financial system. This is referred too as the problem of "too big to fail".
After the collapse of Lehman Brothers, the US Federal Reserve Bank (Fed) had to rescue several other financial institutions because the collapse caused a shock in the entire US financial system. The Fed had to provide AIG (the insurance company) a rescue package of US$ 85 billion, which was one of the largest bails outs in US history. Similarly, during the Eurozone financial crisis, the UK government had to provide RBS and Lloyds a rescue package amounting to staggering £ 1 trillion to help prevent a systemic crisis.
A universal truth about any bank or financial institution is that it cannot withstand a bank run. A bank run occurs when an overwhelming number of customers ask for their deposits back and the bank is unable to meet their demands due to inadequate liquidity. If you remember the film ‘Mary Poppins’ from your childhood, there was one scene where a small boy asks for his deposit back. The conversation is partly overheard by some other customers in the bank who fear that the bank may be in some difficulty and panic ensues with all the customers in the bank demanding back their deposits. A bank run is created leaving the bank with no other option but to close its doors. This film scene is a simple but realistic illustration of a bank run.
In a post consolidation scenario where the financial system is left with systemically significant institutions, a difficulty at one institution could threaten the entire financial system.
Cost of bail outs
The cost of bail out is closely connected to the problem of too big to fail. The central banks or regulators need not intervene in the failure of a financial institution, if it does not cause any adverse impact to the financial system. The depositors of such institution will have recourse in the normal bankruptcy or consumer protection laws of the country. The failure of such a institution will not undermine the confidence of the public in the banking sector or the financial system.
However, if a systemically significant financial institution were to fail, the central banks or regulators would undoubtedly have to step in due to the repercussions it could have on the financial system and the economy. This situation is further complicated when dealing with a consolidated financial sector, where there are only a few large financial institutions and all of them may be systemically significant. The cost of bailing out one systemically significant financial institution alone will be a huge cost due to the sheer size of the balance sheet and throw into the equation a several of these institutions. This will be an unbearable burden to the economy.
When a financial institution has reached the status of too big to fail, its management becomes aware that the central bank or regulator will have to lay out a safety net in the form of bailouts or financial assistance in the event the institution falls in trouble to avoid any adverse impact in the financial system. This leads to the problem of ‘moral hazard’, which means that the implicit existence of a safety net encourages the management of systemically significant financial institutions to behave irresponsibly and engage in risky business. The management are aware that even if they fail the central bank or regulator will bail them out.
One of the main criticisms of the US bail out package during the 2008 financial crisis was that it promoted the above mentioned moral hazard among the senior management of the bailed out institutions. Many felt that it was their conduct that put these intuitions in trouble in the first place and to bail them out was to further incentivise their irresponsible management of the financial institutions.
How to Achieve the Objectives of Financial Sector Consolidation Sans the Drawbacks
In order to achieve the objectives of financial sector consolidation and minimise the risks highlighted above it is necessary for financial institutions to have a proper risk management framework and the central banks or regulators to have the necessary supervisory capabilities. Countries like Canada have succeeded in their consolidation policy because they have in place an appropriate risk management framework and supervisory capabilities that are able to manage the systemic risk created by the consolidated financial sector.
In dealing with the systemic risk posed by the large banks or financial institutions the regulators should take a macro prudential approach to supervision i.e. focus on the financial system as a whole rather than individual financial institutions. This would enable the regulators to proactively identify systemic risk and take any corrective action in the first instance.
Finally, the regulators should be open to experiment with novel regulatory measures that go beyond the current supervisory frameworks. For example, limits on asset-to-capital leverage to prevent unconstrained credit growth or in other words asset bubbles. This is a measure that has been used in Canada with proven success.
This content is accurate and true to the best of the author’s knowledge and is not meant to substitute for formal and individualized advice from a qualified professional.
© 2020 SG