SG is a business consultant specialising, inter alia, in the area of corporate finance including international finance.
What is a Financial Conglomerate?
A financial conglomerate is where several financial service firms are controlled by the same beneficial owner(s). The financial service firms could be in the business of; banking & finance, investment banking, securities, asset management, insurance or any other related business. These firms although separate legal entities are under the same beneficial ownership. These could be organised as a group of individual companies or as coming under a holding structure where all the individual companies are subsidiaries of a holding parent company. Whatever the organisation structure maybe the underlying beneficial ownership of all the financial service firms is the same. Some examples of popular financial conglomerates include; ABN AMRO Group (Netherlands), Santander Group (Spain), Bank of China, DBS Bank (Singapore), Standard Chartered (UK), Lloyds Banking Group (UK), and Scotiabank (Canada).
Advantages of Financial Conglomerates
There are many advantages of financial conglomerates to the owners as well as the customers; hence the reason for their existence. The main motivation for a financial service firm to enter into another related financial service is the fact that it can leverage on its existing financial acumen. This gives it a competitive advantage over any new entrant. There are also synergy benefits and the resultant cost savings, which further reinforce the competitive advantage.
From a customer's perspective all of the above contributes to a superior service at a comparatively lower cost. Furthermore, customers are drawn to and are more likely to feel secure with an already established player in the market rather than a novice, especially considering the nature of the services offered.
The Risk of Financial Conglomerates
Despite the above mentioned advantages of financial conglomerates to customers, they do pose a risk to the financial system. Most financial conglomerates are interconnected in the sense that the individual companies within the conglomerate have many transactions and dealings with each other (commonly known as related party transactions). Because of this interconnectedness if one company falls in trouble it could easily spill over to the other companies in the conglomerate and lead to a failure of the entire financial conglomerate.
The failure of a financial conglomerate has far reaching consequences due to the proportion of financial assets in the system held by such conglomerates. A financial conglomerate is systemically significant and it's failure will definitely cause a shock to the financial system.
Even if the individual companies in a financial conglomerated are not interconnected through related party transactions, the failure of one company could trigger a run (i.e. where an overwhelming number of depositors demand their deposits back) through the 'psychological channel'. This is where due to the group or parent-subsidiary structure, the customers and public perceive the trouble at one individual company as affecting the entire conglomerate.
In the aftermath of the 2008 financial crisis, having witnessed how financial conglomerates contributed in precipitating the crisis, it was proposed that such structures should come under the strict scrutiny of the regulators and further to explore the possibility of deflating the size of financial conglomerates to minimise the systemic risk posed by them.
How to Manage Financial Conglomerate Risk
Although, financial conglomerates pose a significant systemic risk to the financial system given the advantages highlighted above they are especially beneficial to developing economies, which lack financial acumen and have much room for improvement in their financial system. Financial conglomerates could contribute positively to the development of these financial systems and economies.
How can developing economies reap the befits of financial conglomerates and keep the systemic risk posed by them at bay? The answer lies in effective risk management and supervision of financial conglomerates.
The regulators should take a macro prudential approach to the supervision of financial conglomerates where the focus is on the financial system as a whole, as opposed to focusing on individual financial institutions.
The BASEL committee (which is the international standard setting body on banking supervision), the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS), have jointly issued the ‘Principles for the Supervision of Financial Conglomerates’. These principles deal with, among other things, the powers necessary for the multiple regulators to perform group-wide supervision; cooperation and information exchange between regulators; a corporate governance framework for financial conglomerates; capital adequacy on a group basis; liquidity assessment on a group basis; and a comprehensive risk management framework for financial conglomerates.
The regulators should consider adopting the above principles in order to manage the risk posed by financial conglomerates. Further, in developed economies the number of financial service firms in a group could limited to deflate the size of financial conglomerates and thereby minimise the systemic risk posed by them to the financial system.
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.
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