Financial Conglomerates - Modern Banking

Briault (2000) defined a financial conglomerate as a firm that undertakes at least two of five financial activities: intermediary/payments, insurance, securities/corporate finance, fund management and advising on or selling investment products to retail customers. He reports that while in 1978 the vast majority of UK banks engaged in just one of these five activities, by 1998, 8 firms were authorised to offer all five functions, 13 were authorised to offer four, and more than 50 were authorised to offer three.

The Briault figures are for the UK, but rapid growth of financial conglomerates is taking place in the world’s key financial sectors. Financial reform (e.g., ‘‘big bangs’’) in many countries eliminating (to some degree, depending on the country) segmented financial sectors has encouraged banks to become part of financial conglomerates. Given the nature of most activities listed above, virtually all conglomerates are global.

Briault identified the advantages and disadvantages of financial conglomerates. First, the efficiency of the financial system is improved if these conglomerates can achieve economies of scale and scope. Economies of scale is a long-run concept, where all factors of production (e.g., labour, capital, property) are variable. An equiproportional increase in factor inputs leads to a greater than equiproportional increase in output. Firms operate on the falling part of their average cost curves. For example, suppose there are three factor inputs: deposits, labour, property and one output: loans. Then, in the presence of economies of scale, the doubling of deposits, labour and property would result in loans more than doubling.

Economies of scope are said to exist if the joint production of two or more goods or services is cheaper than if they are produced independently, resulting in higher output. Suppose there are two products, x = loans and y = deposits. Then economies of scope exist if C(x, y) < C(x) + C(y), where C is defined as the cost of production. Put another way, average cost falls with an increased number of outputs produced jointly rather than separately.

However, it has proved difficult to produce definitive evidence for the existence of scale and scope economies. Furthermore, any increased efficiency may be offset by the effects of increased monopoly power if the growth of financial conglomerates reduces the number of firms operating in banking and other financial sectors. This will have the effect of raising ‘‘prices’’. The reduced amount of competition in the market could, in turn, increase inefficiency. Hence, it is unclear whether the net effect of financial conglomerates is to raise or lower efficiency.

Second, it is argued that if financial conglomerates locate in countries with emerging financial markets, they can apply their expertise to assist in the development of a country’s financial markets. Often these economies are short of trained labour in their respective financial sectors. The foreign firm can bring in expertise from other countries, but also train and educate the host country labour force.

A third argument is that financial conglomerates usually diversify their financial functions, with branches/subsidiaries around the world, making them less vulnerable to downturns in one economy or region. Likewise, a decline in securities activity may be accompanied by a rise in banking activity. However, as Staikourous and Wood (2001) have shown, diversification may actually increase the financial institutions’ income volatility.

Others have argued that large, diversified financial firms encountering difficulties may ‘‘go for broke’’, adopting high risk/return strategies. If the gamble pays off, the conglomerates survive. If not, their size makes it likely a government might attempt to rescue them should they get into trouble. If, in the absence of a government bailout, they fail, it can trigger the collapse of financial institutions world-wide. Hence, the systemic threat to the global financial system is increased.

Functional supervision normally means independent regulators oversee different functions of the conglomerate – meaning different parts of the conglomerate may be answerable to different regulators. The problem with functional supervision is that damage to the reputation of one part of the firm could cause a loss of confidence in other parts of the firm, including its banking arm. The problem is illustrated by the collapse of British Commonwealth Holdings (BCH), a financial services group, in 1990. After news of serious financial problems in the computer leasing subsidiary of BCH (Atlantic Computers) in April 1990, there was a run on the British and Commonwealth Merchant Bank. Two months later, the Securities and Investment Board34 removed the merchant bank from its approved list, and to prevent a further run, depositors’ funds were frozen by the courts and an administrator appointed. The subsequent report by the administrators found the merchant bank to be financially sound.

In the UK, the Financial Services Authority created a Major Financial Groups Division (MFGD), which is responsible for approximately 50 of the most complex financial firms headquartered in the UK, USA, Japan or Europe. It includes the big four/five UK commercial banks, along with major banks and investment banks from the USA, Europe and Japan. They have been chosen according to size, systemic importance and the complexity of the business within the financial group. The MFGD assigns a ‘‘micro-regulator’’ to each financial conglomerate, which is responsible for coordinating communication among supervisors within the FSA, assessing the group’s overall management and monitoring capital adequacy. A lead regulator is assigned to any firm engaged in several activities but not deemed to be a major financial conglomerate.

In June 1989, the Federal Reserve Bank (Fed) introduced a unique system for large complex banking organisations (LCBOs). Teams of 2–12 supervisors will be assigned to America’s 50 largest LCBOs, most of which operate in global markets. The emphasis is on daily supervision (replacing periodic examinations) of both the banking and trading books. The teams will use an organisation’s risk management and information systems, provided the regulator is satisfied with the quality of internal audit, compliance, risk management and top management.

The main concern with the LCBO arrangement is the risk of regulatory forbearance, when the supervisor puts the interest of the regulated firm ahead of public/taxpayer interest. To counter this problem, teams will be rotated to new LCBOs every 3 years, and other Fed specialists will double-check particularly vulnerable areas.

Managers of financial conglomerates have expressed concern that compliance costs are too high, because most regulators require them to allocate capital (known as dedicated capital) to each of their major operations. For example, if they have businesses in investment banking, stockbroking and intermediary banking, capital must be set aside for each of these divisions. As was noted earlier, in the United States, the FHCs are required to keep insurance, investment and commercial banking activities as separate subsidiaries, which means each subsidiary will have separate capital requirements.

There is also the potential for conflict of interest between the different firms held by the conglomerate. In the UK and elsewhere, the regulatory authorities require firms to erect Chinese walls to prevent sensitive information flowing between the departments (or subsidiaries) of firms, which could create problems such as insider trading. For example, if a mergers and acquisitions department knows of an upcoming bid on a target firm and those working in the trading division are informed of the bid before it becomes public information, the traders who act on such information would be accused of insider trading.

Investigations by US regulators in 2002 uncovered other serious conflicts of interest among modern investment banks that had expanded into brokerage and sales in addition to their traditional activities of underwriting/mergers and acquisitions. The record $1.4 million payout by New York investment banks is worth recalling the reason for the fines, etc. There was evidence of spinning and of bank analysts ‘‘talking up’’ the share price of companies that were also clients of the investment banking division. Thus, the expansion of modern investment banks into the broad range of activities listed previously may bring diversification benefits, but it has also created serious conflicts of interest. Financial conglomerates are also required to impose firewalls to counter the threat of contagion between their different operations. Regulators are especially anxious to keep core bank activities separate from those of other subsidiaries. Firewalls are legal restrictions placed on information flows and financial transactions between subsidiaries, branches, departments or other firms. For example, the Federal Reserve imposed 28 firewalls on section 20 subsidiaries. The main purpose of the firewall is to protect one unit of a holding company from funding problems associated with another subsidiary within the holding company. However, as will be seen below in the ‘‘NatWest’’ case, there are problems with firewalls that tend to arise if one of the subsidiaries gets into trouble.

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