NON-BANK FINANCIAL INSTITUTIONS REGULATORY CHALLENGES Introduction Non-bank financial institutions (NBFIs) have an important role to play in economic

c and financial development. As yet in the Pacific Island countries, NBFIs are not significant and only have a small share of the total assets of the financial sector. This should change. Effective financial intermediation plays a key role in poverty reduction and economic growth. In this part of the world finding innovative ways to provide financial services to the poor so that they can improve their productive capacity and quality of life is a priority task. NBFIs can make valuable contributions in this regard. While NBFIs can contribute to the economy, they also bring risks and the only way to contol these risks is through proper regulation. The challenge for regulation is striking the right balance between the risks and benefits. On the one hand, too little or no regulation can lead to crisis and severely impact the vulnerable and the economy. This has been a major attribute to the Asian crisis in the late 90s finance companies in Thailand and merchang banks in Korea. On the other hand, too strict or inappropriate regulation can stymie innovation and hinder development. The call for deregulation in developed economies reflects this. Getting the right balance is a perpetual challenge for financial regulators and supervisors, not only in the developing countries, but also in developed and advanced economies. This afternoon, I would like to highlight some specific challenges in relation to the supervision of non-bank financial institutions. But I would like to emphasise at the start that I dont have the ultimate solutions, hence the title referring only to challenges. The purpose of this talk is to raise awareness and interest in the subject and I look forward to comments and thoughts from the floor when I finish and open the session to discussion. Some of you would have had first hand experience of the good and evil sides of NBFIs in the region and I urge you to share them. Already a number of the countries represented here have recognised the need to supervise the NBFIs and are in the process of bringing them into the supervisory net. I hope the forum today will help all to understand better the significance of NBFIs, the need for appropriate regulation, the state of development in the Pacific countries and pave the way for future technical assistance in this regard. I will start with an overview of the contributions and risks associated with NBFIs. I will then walk you through the evolution of banking supervision, from why we supervise to how we supervise. After that I will attempt to examine whether and how banking supervision may be extended to the common NBFIs in the region.

Non-bank financial institutions Benefits NBFIs come into existence for various reasons. Some offer financial services that are not appropriate for banks because of the nature of the risks (insurance is an example). Some evolve to fill gaps in the market place (development banks). They often operate as niche providers, capitalising on the benefits of specialisation, especially in information and knowledge. They tend to be more efficient and less costly. The activities of NBFIs serves to enhance competition and increase the depth of the financial market. By reducing concentration and providing alternative sources of finance, NBFIs, as Federal Reserve Chairman Alan Greenspan has said, enhance the resilience of the financial system to economic shocks by providing it with an effective spare tyre in times of need. I am aware that interest spreads are a concern in the region. To the extent that lending rates have been kept high by anti-competitive behaviour, more intemediaries may bring some relief. We know, however, that lack of competition is not the only reason for the lending-deposit spreads in some of the island countries. Weak legal and judicial framework that does not offer appropriate protection of credit rights or enforcement of prudential standards is another impediment to the development of financial intemediation. For both banks and NBFIs to flourish in a healthy financial sector, we need a sound legal and regulatory infrastructure, a widespread credit and savings culture, and the intitutional capactiy for the efficient enforcement of financial contracts. Risks As I alluded to earlier, NBFIs come with their risks. NBFIs can be used as a means to circumvent regulations imposed on banks, thereby reaping a competitive advantage on the regulated institutions. Because they fall out of the regulatory net, they are exposed to the risks that regulations have been designed to mitigate and they are vulnerable when crises hit. So while competition brought about by NBFIs is healthy, it is unhealthy when it is based on lax regulation. Countries should guard against regulatory arbitrage when different institutions subject to different regulatory constraints can offer the same type of products. Here in particular, we have to be careful that banks would not be allowed to operate large NBFIs without regulation. This has been the cause of demise of a few banks in the last decade. We dont have to look very far to find examples two State banks in Australia have to be taken over because of high-risk activities undertaken in their unregulated and very large non-bank subsidiaries. NBFIs can also be popular vehicles for money laundering and financing of terrorism. In recognition of this, the Financial Action Task Force has expanded its definition of financial institutions in the FATFs recommendations to cover a wide range of NBFIs.

In fact, the recent revision to the recommendation has broadened the coverage even further to include non-financial businesses and professions. Generally all NBFIs make promises to pay and customers are therefore exposed to the risk that the promises would not be honoured. This is one of the primary reasons for banking supervision and regulation that depositors are protected against the banks failure to repay. In a perfect market, we would expect individual depositors, policy holders and investors to have information based on which they can assess the institutions before they enter into any deals. The reality is information is not always reliable and customers lack expertise to analyse the information to determine the value of promises made to them by financial institutions. The regulators role is to ensure that those promises are reasonable, understandable and adequately backed by capital reserves. It is obvious that NBFIs pose no less risk than banks and therefore warrant some form of regulation. Before we consider how to go about it, let me take you through the evolution of banking supervision to see what lessons we can learn from it. Banking regulation and supervision Why do we regulate? I have already mentioned the need for regulators to underpin the assessments of the financial promises made by banks, and other financial institutions. Banks have always held the dominant position in the financial system. They provide the backbone of the payment systems and are the main conduit of monetary policy. The huge leverage with which they operate and the nature of their balance sheet, comprising short term liabilities and much longer term assets, expose them to a variety of risks, including credit, liquidity, interest rate and currency risks. They are also subject to operational risks like fraud and abuse. Above all, because banks operate on trust, a slip in confidence could generate huge contagion effect and trigger runs and failures with disruptive consequences for the economy. As a result, banks have received more policy attention than other sectors of the financial system. In all developed economies, banks are subject to varying degrees of regulation and supervision. There has also been significant progress in harmonising the banking supervisory framework across borders, evidenced by the 1988 Capital Accord, and the more recent Core Principles for Effective Banking Supervision, both sponsored by the Basle Committee on Banking Supervision. How do we regulate? The primary building block of effective supervision is legislation that will provide the regulator with a comprehensive set of powers to meet its objectives.

The standard processes of supervision involve: Licensing Licensing plays an important role in ensuring the viability of new banks and the integrity and fitness of those who will control and manage the banks. The licence should be conditional and be maintained only if the bank keeps to the conditions, and need to be reviewed whenever there are significant changes in ownership, expansion into new activities, appointment of directors and senior management, and changes in the composition of capital. Prudential standards Fundamental capital rule sets the minimum buffer to absorb potential losses. Other rules set limits that aim to diversify risks and ensure that minimum levels of liquid and prime assets are met. Reflecting a trend to expand from the traditional quantitative regulations to include qualitative standards, there is increasing onus on bank management to adopt appropriate systems and procedures to monitor and control the various risks. On-going surveillance Offsite surveillance involves the on-going evaluation of a banks financial performance, based on reported information from the bank. It facilitates the early identification of problems, and helps to target scarce supervisory resources to areas of greatest risk. Onsite examination normally focuses on asset quality, and increasingly on a banks internal policies and controls and an assessment of management quality. Enforcement Speedy intervention is crucial to minimise the costs associated with bank failure. Supervisors need an array of tools at their disposal to deal with problem banks from issuing adminstrative sanctions and levying fines, issuing directions and enforceable undertakings, appointing statutory managers, arranging mergers and ultimately putting a bank into liquidation. Applying supervision to NBFIs There is general consensus that NBFIs need to be supervised. Rather the debate internationally has been on regulatory structure whether supervision should be undertaken by separate industry regulators or by an integrated supervisor. This debate has little relevance in the region where the relatively small size of the industries and the shortage of resources cannot support multiple regulatory agencies. By default we have integrated supervisors so it is befitting that we adopt their motto to regulate similar risks in a similar manner. Let us examine the common types of NBFIs in the region and see how this can be done. Insurance companies By providing contingent promises insurers offer a risk management tool enabling those who are least able to bear the risk to transfer, at a cost, those risks to those who are able to manage them. With the vulnerabilities to natural disasters in this region, people are exposed to their risks and consequent income fluctuations. Taking insurance cover can

offset this. As custodians of peoples savings, banks are risk averse and not suited to take on general insurance risks. Life insurance companies mobilise savings from the household sector and channel them to the corporate and public sectors. The key difference between banks and life insurers is that the maturity of liabilities in banks is generally shorter than those of life insurance companies. This enables life insurers to play a large role in long-term financing. At the same time, life insurers portfolios are typically more liquid than those of banks, making them less prone to liquidity crises. For insurers, the risks that impact on their ability to pay can be classified into three main categories technical risks, asset risks and other. Technical risks arise from the very nature of the insurance business hinging on the determination of liabilities. Insurance liabilities are estimated using actuarial or statistical techniques, based on probability using past experience and making assumptions about the future. If these calculations are incorrect, liabilities would be understated or premiums would be undercharged, both would distort the insurers true financial position and lead to liquidity or even solvency problems. Underpricing, unforeseen or inadequately understood events, and insufficient reinsurance are all examples of technical risks. On the asset side, insurers face market risk, credit risk and to a lesser degree, liquidity risk. Other risks include legal and operational risks. On top of all the risks, the heterogeneous nature of the insurance industry with life and non-life insurers as well as reinsurers and the wide range of risks even for insurers in the same country or market, all add to the difficulty in insurance supervision. Internationally the supervision and regulation of insurance lags behind that of banking and is far from consistent. This deficiency has come to the fore and we are seeing progress through the efforts of the International Association of Insurance Supervisors. The standard bank supervisory process has been adopted by insurance supervisors, with differences mainly in the details of the quantitative prudential standards in establishing adequate technical provisions and other liabilities, and to require robust underwriting and pricing policies. In subjecting insurers to supervision, the full bank supervisory process, from licensing through to enforcement, is applicable. Provident funds/superannuation Mandatory contributions from both employees and employers have resulted in a significant growth in the size of provident funds in a number of Pacific countries in the last few years. The growth is set to continue with fund assets making up an increasing share of total financial sector assets. Longer life spans generally have heightened the need for a reliable source of retirement income. A major risk for superannuation is investment or portfolio risk and one of the key mitigants is proper portfolio diversification. This has posed difficulties in the Pacific countries because of a lack of investment media and opportunities, made more restrictive when overseas investments are forbidden or restricted under exchange control rules. As a result these funds carry substantial systemic risks from the financial system and the economy. A general downturn in the economy can have multiple impacts with forced

retirements or redundancies coincident with negative investment returns and a loss of contributions. Provident funds are highly exposed to operational risks like fraud, misfeasance, malfeasance, exorbitant fees, or outright theft of assets. Generally the bank supervisory process including licensing, prudential standards, ongoing monitoring and enforcement apply to the supervision of provident funds. Here in the region where most countries only have one government provident fund, licensing is irrelevant. However, rules for fitness and propriety of the board (where there is one) and the managers and administrators are essential. A key prudential standard will be in respect of investment regulation, to ensure diversification and minimize portfolio risk. Regulations typically restrict holdings by issuer, by type of investment, by risk, by concentration of ownership, and by asset class. The last is controversial. Some regulators set ceilings by asset class while others adopt the prudent man rule, ie, simply requiring those that make the investment decisions to exercise diligence and expertise having regard to the funds characteristics. For funds with explicit obligation to produce minimum returns, reserving requirements would need to be commensurate with the obligation. Development banks Development banks fill a financing gap for start-up businesses that cannot attract funding from banks as the latter usually look for a demonstrated track record of profitability before they would commit to lend. Development banks are also prepared to lend for a longer period than commercial banks; they are the primary source of credit for large structural projects involving huge outlays and a long payback period. Longer payback periods and uncertainties linked to start-ups warrant close monitoring when the loans are outstanding, to enable early identification of problems and intervention or remedial actions where appropriate. The higher risks and maintenance associated with such lending should be associated with higher returns, ie, higher interest rates, but often funds are lent at concessional interest rates to facilitate governments to achieve their economic or social policy objectives. I understand a number of the Pacific countries had their fair share of experiences with Development Banks but as they are mostly before my time I may leave the stories for others to tell. I hope those of you who were either on the inside or outside of those banks will share your insights later on. From a supervisors perspective, where the development bank is not funded by depositors funds, the rationale to supervise to ensure repayment promises would be honoured is weaker. However, as the losses ultimately affect the public, there are strong feelings that development banks operations should come under closer scrutiny. As the main risk is credit, the banking supervisors skills and expertise would be handy. Regular

onsite examination of credit quality and provisioning practices should be a backbone to the supervision of development banks. Microfinance providers In a lot of rural areas in the region, people have no access to financial services. The big banks are not interested in doing business in these areas because of the high cost in setting up infrastructure, perceived low profitability from the small transactions involved, and above all the unavailability of collateral generally required by these institutions. Having access to credit facilities will enable the poor to develop business enterprises, increase income earning capacity and ultimately attain a higher standard of living. While micro-finance services have developed quite extensively in Asia and Latin America, they are not yet very popular in the region. I understand micro-credit schemes have been identified for further work at the recent Forum Economic Ministers meeting. To the extent that these services were run by nongovernment organisations with donor finance, prudential supervision has not been seen as necessary. As their operations grow, there would be needs to borrow or gather deposits. We have witnessed in Asia and Latin America some success in transformation of NGO credit providers to licensed financial institutions. Becoming licensed and regulated have generated benefits in: better management and governance, and higher profitability and hence sustainability; increased access to loanable funds from commercial sources; broader range of products such as deposits, money transfers, leasing, and payment services; and increased breadth and depth of outreach.

Credit Unions A credit union is formed by a group of individuals who share a common interest, for instance, working for the same employer; living in the same island; or belonging to the same ethnic group. Membership is open to all people with the common bond and is voluntary. The guiding principles are democracy, equity and solidarity. Members have equal voting rights and are entitled to participate in decisions that affect the credit union. The purpose is to provide self-helpservices to members, to improve the economic and social well being of all its members, to encourage savings and ensure a fair rate of interest is paid on savings deposits. A credit union is a co-operative bank with funding provided by members pooling their savings and lending only to members. To the extent that it is a closed shop looking after its own interest, there appears to be little ground for supervision. However as a credit union grows, it becomes more exposed to operational risks. Being a credit institution, it is also exposed to credit and liquidity risks. For credit unions to be more effective in achieving their goals, they need to be managed on a more business-like footing. We see merit in subjecting the bigger credit unions to prudential standards governing credit and liquidity, and for key personnel to meet fit and proper standards to guard against fraud and other operational risks. Although as mutuals credit unions do not have capital, they must nevertheless be obliged to have positive net

worth at all times and made to build reserves as buffers to absorb losses. For very small credit unions with relatively few members, a judgement needs to be made whether the low risk justifies the supervisory costs. Money transferors/Alternative remittance system These are used by people who have no access to banks, for example illegal migrants or people living in remote areas, to send money across countries. They are cheap (low fees), fast and efficient (money often available within hours). They are available everywhere (in remote areas where there are no banks) and anytime (24 hours a day, 7 days a week). Authorities have tended to turn a blind eye so as to allow the unbanked an option to move money across borders, on the basis that the majority of transactions are for legitimate purposes and for small amounts. A feature of these alternative remittance operations is that little information is required from users; often a code, rather than the true name, is used for identification. Also minimal records are kept after the transactions are completed. As a result, these operations are attractive avenues for money laundering and financing of illegal and terrorist activities. The need to comply with FATF Recommendations is now posing a challenge for regulators. We need to be sensitive to why these remittance systems have come into existence and acknowledge that any attempt to regulate them would probably only push them further underground. Registration or licensing without imposing regulations can be a first step. In the longer term, licensed service providers should be encouraged to improve services in terms of cost, speed, efficiency, geographical coverage and operating hours. Authorities should conduct public awareness programs to educate the public about the risks of using unlicensed operators. Efforts should be devoted to develop alternative systems or instruments to meet the needs of overseas workers to send money across borders. Governance Irrespective of how we broaden supervision and the extent of regulation, an overriding ingredient that must be instilled is good governance. Given the multiple roles of government in finance, including: as regulator of financial institutions; as owner of financial institutions; as lenders and guarantors; as market participants through issuing and trading debt; and as fiduciary agent in pension schemes

strong public sector governance is of paramount importance. This is a very relevant topic in the region because here you have a fairly high level of public sector participation in the ownership of both banks and NBFIs. When standards in government are low, we would get badly-run publicly-owned financial institutions that distort competition and retard economic growth. The government cannot expect the private sector to adhere to prudent behaviour if it does not set a good example. The way the government handles conflicts of interest, privileged information and disclosure will have an important bearing on the integrity of the financial markets. In my role as financial sector supervision advisor today, I want to emphasise two top priorities to achieve strong governance in the regulator. One is independence for the regulatory agencies. Independence means that the regulator is empowered to develop regulatory policies, to implement them and enforce them without inappropriate interference from Government or from industry. Independence frees the regulator from extraneous considerations and influences that can bias decision making. Independence is achieved when the legal structure does not allow the Government to overrule the regulators decisions and policies, when there is due process for the appointment and dismissal of the regulatory board, and when staff of the agency are indemnified when acting in good faith in the discharge of their duties. The second is transparency and accountability, the essential measures to keep independence in check. There must be accountability and transparency in the way in which the regulator reports its finances and account, to the Parliament and to industry; the extent to which industry can comment on and be a part of policy changes; and the mechanisms for the resolution of disputes. Conclusion NBFIs have much to contribute but they also bring with them risks. The risks should be contained by sound regulation that seeks to create a generally level playing field, without stifling growth or the individuality of the different types of institutions. How do we do it? There is no one size fits all solution. The approach taken should reflect the countrys individual conditions state of economic development, size of the NBFIs, nature of their businesses. The strategy should keep pace with market developments, to achieve an optimal balance between risks and benefits. Generally, effective supervision requires appropriate legal powers, prudential standards and regulations and expertise in implementation and enforcement. Proper sequencing is important - take one step at a time and dont extend the net too widely. The pre-requisite is to build an effective and efficient supervisory agency - resource it properly with skilled staff; give it independence but demand accountability and transparency.

PFTAC stands ready to help build skills and capacity. Sharing experiences and learning from each other also help regulatory staff deal with evolving challenges. Please support the Association of Financial Supervisors of Pacific Countries towards achieving its objectives - to promote closer co-operation and coordinate information sharing in financial regulation and supervision in Pacific countries; enhance supervisory skills; encourage the development of high professional standards; and strengthen the financial sectors of Pacific countries.

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