Trends in Financial Conglomeration

A. Overview of the Philippine Financial Sector

The Philippine financial system consists of banks and nonbank financial institutions (NBFIs). Banks are classified into the categories of universal banks (or expanded commercial banks), commercial banks, thrift banks (savings and mortgage banks, stock savings and loan associations, and private development banks), rural banks, cooperative banks, and Islamic banks. NBFIs include insurance companies, investment houses, financing companies, securities dealers and brokers, fund managers, lending investors, pension funds, pawn shops, and nonstock savings and loan associations.

Figure 1 [ PDF 77.2KB | 1 pages ] shows the total assets of the Philippine financial system from 1980 to 2006. Total assets of the financial system as a percentage of GDP rose from around 102% in 1980 to 117% in 1983, and then continuously declined to 66% in 1988 as a result of the financial and economic crises in the mid-1980s. The ratio in 1988 was around the same level as that in 1970. The ratio then steadily rose to around 140% in 1997. But the trend was again reversed in the aftermath of the Asian financial crisis, with the ratio falling to its 1980 level of 102% in 2006. Thus, there has been no significant and consistent growth in the size of the Philippine financial sector in the past 35 years.

Source of basic data: Bangko Sentral ng Pilipinas; National Statistical Coordination Board. The Philippine financial system has consistently been dominated by banks, particularly commercial banks.³ In fact, the importance of commercial banks has increased over time. The banking system accounted for 81% of total financial assets in 2006, compared to around 76% in 1970. The asset share of commercial banks also increased from around 57% in 1970 to 72% in 2006. Total assets of commercial banks grew significantly in the 1990s due to the successive increases in minimum capital requirements, the upgrading of the specialized government banks into universal banks, and the entry of new local and foreign banks. In particular, universal banks dominate with an asset share of 80% of total commercial banking assets in 2006. In contrast, the asset share of rural banks fell from around 3% in the 1970s to 2% in 2006, while the asset share of thrift banks only slightly rose to 7% in 2006 from 4% in 1970. In contrast, the share of NBFIs in total financial assets fell from a high of 28% in 1975 to 19% in 2006. The dominant sector under NBFIs is the insurance sector. In fact, the share of the insurance sector in total NBFI assets significantly increased over the past two decades, from 47% in 1980 to almost 80% in 2005. However, around 60% of the assets of the insurance sector were in turn accounted for by two government insurance corporations: the Government Service Insurance System (GSIS) and the Social Security System (SSS).

Thus, there has been no significant structural change in the Philippine financial sector. A bank-dominated financial system is not necessarily bad. The issue is whether such a structure is a market outcome or the result of government regulation. In the case of the Philippines, it was clearly the latter. The banking sector has historically been the focus of financial sector policy, development, and reform. In contrast, efforts to reform and develop the other sectors of the financial system began only in the mid-1990s. A theory on the relationship between financial development and economic development in a market-oriented economy posits that the banking system, which initially leads financial development, declines in importance as real growth and financial development continue (Goldsmith, 1969). One observed characteristic of the process of economic development over time in a market- oriented economy is an expansion and elaboration of the financial structure (institutions, instruments, and activities). On the other hand, economic development is retarded if financial intermediaries do not evolve (Patrick, 1966). This theory has been borne out by recent empirical literature.⁴

The dominance of banks in the financial system is not unique to the Philippines. Banks continue to be the biggest sector in most financial systems in East Asia, although there has been progress in diversifying financial markets especially after the 1997 Asian financial crisis. In particular, the focus of policymakers in the region has been to develop the equity and bond markets (Ghosh, 2006). Table 1 [ PDF 73.9KB | 1 pages ] shows the structure of financial systems in East Asia. Overall, financial development in the Philippines lags behind other comparable countries in the region, particularly Thailand and Malaysia.

Given the dominance of universal banks in the Philippine financial sector, the next section discusses Philippine and worldwide trends in financial conglomeration.

B. Overview of Financial Conglomerates in the Philippines

Figure 2 [ PDF 74.7KB | 1 pages ] presents three alternative structures for the undertaking of nontraditional activities by commercial banks: the universal bank, in which the nontraditional activity is consolidated within the same corporate unit as the bank; the holding company affiliate, in which the bank is in one subsidiary of a holding company and the nontraditional activity is in another subsidiary of the holding company; and the operating subsidiary, in which the nontraditional activity is located in a subsidiary of the bank (Shull and White, 1998). A pure universal bank is one that manufactures and distributes all financial services within a single corporate structure, while the German variant combines commercial and investment banking in a single corporation but conducts other financial activities through separately capitalized subsidiaries. A universal bank can also be considered a financial conglomerate. The Joint Forum on Financial Conglomerates⁵ defines financial conglomerates as "any group of companies under common control whose exclusive or predominant activities consist of providing significant services in at least two different financial sectors (banking, securities, insurance)" (Joint Forum, 1995: 1). Bancassurance, a marketing arrangement wherein banks sell insurance products, that involves affiliated firms also meets the definition of a financial conglomerate. The structure that a bank adopts in delivering integrated financial services is influenced primarily by regulation. There are also other factors, including the historical development of a country’s financial markets, market power, and economies of scale and scope (Skipper, 2000).

The Philippines introduced extended commercial banking or the German variant of universal banking as part of the initial financial liberalization program in 1980. A universal bank was allowed to perform the functions of an investment house either directly or indirectly through a subsidiary. Table 2 [ PDF 72.6KB | 1 pages ] shows the number of commercial and universal banks from 1980 to 2006. In contrast to previous decades, the period after 1995 was characterized by significant movement in terms of new entries and consolidations. In particular, the number of foreign bank branches and subsidiaries increased as a result of deregulation of foreign entry in 1994. The number of private domestic banks also increased in the first half of the 1990s as a result of deregulation of entry, and then decreased towards the latter half of that decade due to mergers and acquisitions.

Thus, in contrast to other developing countries, the Philippines has had a long history of universal banking. In addition, the country has continued to follow a policy of despecialization by allowing banks to further widen their range of permissible activities and products. Table 3 [ PDF 72.6KB | 1 pages ] presents the current ceilings on equity investments of banks. Cross-selling was also allowed under the new General Banking Law of 2000, and bancassurance was formally introduced in 2002. Initially, Bangko Sentral ng Pilipinas (BSP) planned to allow universal and commercial banks to sell only their subsidiaries’ financial products, such as mutual funds and life insurance. A subsidiary is defined as a firm in which a bank has at least a 51% stake. The Monetary Board later decided to include banks’ affiliates, which were then liberally defined as financial allied firms in which banks had at least a 5% stake, after foreign insurance companies argued that the subsidiary requirement favored only two universal banks. The Philippines’ relatively unrestrictive stance on banks’ allowable activities is further highlighted when compared to other countries in the region (Table 4 [ PDF 75.3KB | 1 pages ]).

In 2004, BSP undertook a conglomerate-mapping exercise to facilitate its supervisory work. The focus of the exercise was on private domestic banks and their subsidiaries and affiliates. The exercise showed that nine universal banks and one commercial bank could be considered as constituting the core financial conglomerates, according to the definition of the Joint Forum on Financial Conglomerates. The 10 banks accounted for 58% of the total assets of the commercial banking system.

The average number of subsidiaries and affiliates was 27. The nine universal banks, which are the only banks allowed to have non-allied subsidiaries or affiliates, could be considered mixed conglomerates. The average number of non-allied subsidiaries and affiliates was six. These ten financial conglomerates are still primarily banking in nature. On average, total assets from the parent bank to the consolidated group increased by only 6%. Furthermore, lending activities are still conducted in their parent bank. The average increase in total loans was only 8%, from the parent bank to the consolidated group (Yuvienco, 2007).

Table 5 [ PDF 94.6KB | 1 pages ] gives a summary of various subsidiaries and affiliates of the universal banks in 2005 or 2006. The results show that only four banks have diversified holdings – the two biggest banks (Metropolitan Bank and BPI) and two smaller-sized banks (Allied and RCBC).

Table 6 [ PDF 72.7KB | 1 pages ] presents measures of consolidation and diversification of banking sector activities in selected East Asian economies. The results show that significant consolidation has taken place in the region since the Asian financial crisis, as indicated by the large rise in the median size of banks. This is also true in the Philippines, but Philippine banks are considerably smaller compared to banks in similar economies such as Malaysia and Thailand. Although it is not easy to systematically measure the range of services being provided by the banks, the income diversification index indicates that banks have broadened their range of services as well. This is especially true in Malaysia, the Philippines and Thailand (Ghosh 2006).

Figure 3 [ PDF 72.7KB | 1 pages ] shows the distribution of total operating income of commercial banks in the Philippines. Net interest income is still the dominant source for commercial banks. Its share steadily increased from 1993 to 1998. Non-interest income became more important in the years following the Asian financial crisis. During that period, fee-based income accounted for around 12% of total operating income, and other non-interest income accounted for 20–30%. Table 7 [ PDF 72.9KB | 1 pages ] presents the income diversification index by type of commercial bank in the Philippines. The results show a similar pattern and indicate a high level of income diversification particularly for domestic and foreign banks. The government universal banks are the least diversified in terms of income source.

Ghosh (2006) also undertook a cross-country regression analysis on a sample of the largest publicly listed and private commercial banks to determine the impact of these structural changes on banking sector efficiency. Included in the analysis were the economies of Hong Kong, China; Indonesia; the Republic of Korea; Malaysia; the Philippines; Singapore; and Thailand. These results indicate that larger banks and banks that are undertaking a broader range of activities are not yet enjoying economies of scale and scope. That is, banks’ operating income would be much higher if they were broken up into financial intermediaries specializing in individual activities, rather than if they were engaged in multiple activities. This result does not augur well for the Philippines, given its high level of consolidation and diversification of banking sector activities.

C. Worldwide Trends in Financial Conglomeration

The Philippine experience is similar to other developing and emerging markets, where financial conglomeration is typically discussed in the context of banks. However, De Nicoló et al. (2003) note that this is not dissimilar to the case of industrialized countries where the reasons for conglomeration are often the same albeit with different catalysts. In particular, macroeconomic pressures and banking crises in the 1990s led governments to undertake deregulation. This, combined with higher capital requirements caused banks to be more competitive as their profit margins declined. In countries where there was no prohibition on universal banking, banks moved towards nontraditional banking activities. Other countries explicitly introduced legislation to allow banks to broaden their range of activities.

De Nicoló et al. (2003) documented worldwide trends in financial conglomeration by examining firm level data from the Worldscope database for the top 500 financial institutions according to total assets. Financial institutions are classified as conglomerates if they undertake at least two of the three major lines of business or activity (i.e., banking, insurance, securities investment). Table 8 [ PDF 93.6KB | 1 pages ] presents some summary statistics of worldwide financial conglomeration in 1995 and 2000.

These results indicate that there has been a significant increase in financial conglomeration between 1995 and 2000, both in terms of the number of financial conglomerates and their asset share. In 1995, 42% of the top 500 financial institutions were classified as conglomerates. This increased to 60% in 2000. In terms of asset share, financial conglomerates accounted for 80% of total assets in 2000, a slight increase from the 72% asset share in 1995. The study also found that the rate of conglomeration rises with the asset size of financial institutions. For instance, in the top 50 institutions in 2000, 92% were classified as conglomerates with an asset share of 94%.

Not surprisingly, the study found that industrialized countries dominated the sample, although their performance differed according to region. For instance, Western Europe has quite a long history of conglomeration. In contrast, restrictions on allowable activities of financial intermediaries have only been recently lifted in the US and Japan. The trend is also increasingly becoming a feature of emerging markets. The 38 financial institutions included in the sample in 1995 came from only a few emerging market countries (Brazil; Greece; the Republic of Korea; Malaysia; South Africa; Taipei, China; and Thailand). The number rose in 2000 due to the substantial growth in asset size of financial institutions in the emerging market economies of Eastern Europe, Asia, Latin America, and the Middle East.

Finally, in terms of industry type, the results show the dominance of financial institutions classified as banks. The number of banks represented around 72% of the sample, with an asset share of more than 70%. In particular, the number of banks classified as conglomerates significantly increased from 43% of the total number of banks in the sample in 1995, to 68% in 2000. Asset share of banks classified as conglomerates also increased from 75% of total bank assets in 1995 to 86% in 2000.

The IMF (2001) also noted that the trend toward consolidation of bank with nonbank financial activities is beginning to gain ground in emerging markets. Most emerging markets have followed the universal banking paradigm. Furthermore, banks typically dominate local capital markets, which mean they directly share in the growth of these markets. In Asia in particular, while financial services integration is at an early stage, Palmer (2002) argued that there is significant scope for convergence across Asia. Universal banking models incorporating commercial banking, insurance and securities activities already exist in many Asian countries and the remaining restrictions on financial conglomerates operating across sectors are bound to diminish. Bancassurance is also slowly taking hold. The Asian financial crisis also spurred liberalization and deregulation efforts, which can accelerate integration. In addition, banks in Asia have been designated a key role in the development of the region’s capital markets. Commercial banks already play a major role in corporate bond markets as issuers, underwriters, investors, and guarantors. This reflects banks’ dominance of their financial markets, their high reputation, and the informational advantages they enjoy. Thus, it has been recommended that banks be further encouraged to foster corporate bond market development and pursue a complementary role. In addition to securities and derivatives businesses, banks may also be encouraged to engage in other nonbanking activities such as insurance underwriting (Shirai, 2001; Yoshitomi and Shirai, 2001).

Due to underlying factors driving it, financial convergence and conglomeration is expected to continue. The speed and extent of convergence, though, will not be the same for every country. It will depend on various factors, including the needs of the local market, the stage of development of the economy, various macroeconomic factors and the extent to which regulatory reforms allow banks to diversify (Palmer, 2002). But the common issue is how regulators can best respond to financial conglomeration. In particular, the emergence of financial conglomerates adds at least two new dimensions to the supervision 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). The ultimate question is, if financial sectors are integrating, should regulators do the same?

D. Current Supervision of Philippine Financial Conglomerates

The Philippines essentially follows the traditional "pillars" approach in regulating and supervising the three major financial sectors—the Securities and Exchange Commission SEC) for the securities market, the Insurance Commission (IC) for the private insurance sector, and BSP for the banking sector. Needless to say, each agency operates under different sets of rules, principles and standards, resulting in differing qualities of supervision that proved problematic especially in the aftermath of the Asian financial crisis.⁶

The Philippines does not currently have a legally embedded definition of financial conglomerates. With respect to supervising financial conglomerates, that is, universal banks, the regulatory framework is fragmented. BSP has supervisory authority over banks and quasi-banks and their subsidiaries and affiliates engaged in allied activities. Non-allied entities are subject to BSP examination only if they are at least majority-owned or controlled by a bank. 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 Securities and Exchange Commission and the Office of the Insurance Commission under relevant laws. BSP moved towards consolidated supervision of banking groups beginning in the late 1990s, but it concedes that its application is still rudimentary because existing laws preclude its full implementation.

To somewhat address the fragmented nature of financial supervision of a universal bank, the three financial supervisors plus the Philippine Deposit and Insurance Corporation (PDIC) formed the Financial Sector Forum (FSF) in 2004. The FSF is not a financial regulatory body. The aim of the FSF is to provide the four financial agencies a mechanism for cooperation, coordination, information sharing and harmonization to address inconsistencies in the supervision and regulation of the different financial entities within the conglomerate that could lead to regulatory arbitrage. Financial regulatory issues that the group has sought to address include: (i) harmonization of regulation of products offered by banks, securities dealers and insurance companies that are similar in nature; (ii) comparison of capital adequacy requirements; and (iii) making the requirements and procedures for accrediting reputation agents, such as making external auditors more uniform (Yuvienco, 2007).

The FSF is certainly a step in the right direction in terms of making the quality of supervision across the different components of a universal bank more consistent. However, the FSF is not a formal organization, and therein lies its weakness. Participation in the group is voluntary, so, technically, agreements reached are legally nonbinding. The group primarily operates through moral suasion. But the group is bound to face some policy and practical issues that may be very difficult to resolve due to significant differences in regulatory frameworks. The question is whether the group would be able to withstand such pressures and maintain its cohesion. One option would be to formalize the FSF and appoint a lead regulator. Since financial conglomerates in the Philippines are still largely banking in nature, then BSP is the natural lead regulator. BSP then becomes responsible with the added duty of overseeing the entire banking group’s operation and ensuring coordination of responses, without usurping the power of other regulators. The next section discusses the supervisory implications of financial conglomeration more fully.

Download this Discussion Paper [ PDF 711.9KB| 68 pages ].

Comment(s)

There are [0] comment(s) for this entry. Post a comment.