Chapter 6 Assessing the Supervision of 6 Other Financial Intermediaries 6.1 Overview This chapter focuses on issues in the regulation of a range of non-bank financial institu tions (NBFIs),categorized as Other Financial Intermediaries (OFIs).OFIs refer to those financial corporations that are primarily engaged in financial intermediation-that is, corporations that channel funds from lenders to borrowers through their own account or in auxiliary financial activities that are closely related to financial intermediationbut are not classified as deposit takers (IMF 2004a).OFIs include insurance corporations pension funds;securities dealers;investment funds;finance,leasing,and factoring com- panies;and asset management companies.This chapter discusses considerations in assess- ing the regulation and supervision of OFls(other than insurance companies and security market intermediaries)generally,with a focus on specialized finance institutions,leasing and factoring companies,and pension funds. Although OFls are often dwarfed by commercial banks in terms of volume of business and size of assets,OFIs should receive adequate attention during the assessment process for various reasons.OFIs play an important developmental role through their activity in areas and mark he presence of commercial banks isnot fully felt.Moreover,th development of OFIs could increase bank competition,which could lead to greater access to finance.In many countries,pension funds are major contractual savings institutions with a significant effect on financial markets and the macroeconomy. Specialized financial institutions (such as thrifts,building societies,and mortgag institutions)have emerged in many countries to carry out real estate finance.However,in many countries,other than their specialization in housing finance,those institutions are
171 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 6.1 Overview This chapter focuses on issues in the regulation of a range of non-bank financial institutions (NBFIs), categorized as Other Financial Intermediaries (OFIs). OFIs refer to those financial corporations that are primarily engaged in financial intermediation—that is, corporations that channel funds from lenders to borrowers through their own account or in auxiliary financial activities that are closely related to financial intermediation—but are not classified as deposit takers (IMF 2004a).1 OFIs include insurance corporations; pension funds; securities dealers; investment funds; finance, leasing, and factoring companies; and asset management companies. This chapter discusses considerations in assessing the regulation and supervision of OFIs (other than insurance companies and security market intermediaries) generally, with a focus on specialized finance institutions, leasing and factoring companies, and pension funds. Although OFIs are often dwarfed by commercial banks in terms of volume of business and size of assets, OFIs should receive adequate attention during the assessment process for various reasons. OFIs play an important developmental role through their activity in areas and markets where the presence of commercial banks is not fully felt. Moreover, the development of OFIs could increase bank competition, which could lead to greater access to finance. In many countries, pension funds are major contractual savings institutions with a significant effect on financial markets and the macroeconomy. Specialized financial institutions (such as thrifts, building societies, and mortgage institutions) have emerged in many countries to carry out real estate finance. However, in many countries, other than their specialization in housing finance, those institutions are Chapter 6 Assessing the Supervision of Other Financial Intermediaries
Financial Sector Assessment:A Handbook indistinguishable from deposit-taking institutions such as banks,and they require atten tion from both the stability and the development perspectives. Leasing companies engage in relatively simple transactions where the lessee (a busi- ness owner)uses the asset (owned by the leasing company)for a fixed period of time, while making payments on a set schedule.At the end of the lease,the lessee buys the asset ing hinvmin companies can serve as a significant so ms wanting to inves inqmtand that investment ineaincompen yield attractiveretumif conditions are right. Factoring companies are financial institutions that specialize in the business of accounts receivable management.Factoring is an important source of external financing 6 for corporations and small and medium enterprises(SMEs),which receive credit based on the value of their nts eivables.Under this form of asset-based finance,the credit provided by a lender is explicitly linked ona formula basis to the value of a borrower underlying assets (working capital),not to the borrower's overall creditworthiness.In developing countries,factoring offers several advantages over other types of lending.First. factoring may be particularly useful in countries with weak secured-lending laws,inef- ficient bankruptcy systems,and imperfect records of upholding seniority claims,because part of the estate of a bankrupt SME.Second,in a factoring is arily based on 9 of the underlying isk SME ecorin may beepeciallyi ohigh- The development of Ofls such as leasing and factoring companies (especially if thev were operated by groups that were independent of large banks and insurance companies) increases lending to smaller borrowers.Some practitioners argue that stand-alone OFIs tend to compere more vigorously.for that r onal Finance Corporation prefers ance asing con despit their disadv antage wher compe can tap into low-cost depositors funding from their parent companies)(International Finance Corporation 1996). While the small size of the OFI sector in some countries may limit OFI's systemic effect on the rest of the financial sector in case of crisis,stress in OFIs could have systemic effects in specific circumstances.In particular,difficulties in OFls may have some systemic effect,insc ey trigger a loss onfidence in dep ect of the financial systemt effective regulations for OFIs can exacerbate the fragility of the overall financial system through regulatory arbitrage(Herring and Santomero 1999). In many countries,pension funds are a major source of contractual savings,providing a stable source of long-term investment to support growth and at the same time playing a key role in financial markets through their nent behavior.National pension tems provide retirement in ome from a mixture of govern emplo vidual savings.Pension funds affect the stability of financial markets and the distribution of risks among different sectors of the economy by their investment behavior and the way they manage their risk. 172
172 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 indistinguishable from deposit-taking institutions such as banks, and they require attention from both the stability and the development perspectives. Leasing companies engage in relatively simple transactions where the lessee (a business owner) uses the asset (owned by the leasing company) for a fixed period of time, while making payments on a set schedule. At the end of the lease, the lessee buys the asset for a nominal fee, giving the lessee the opportunity to make a capital investment. Leasing companies can serve as a significant source of finance for small firms wanting to invest in equipment, and that investment in leasing companies can yield attractive returns if conditions are right. Factoring companies are financial institutions that specialize in the business of accounts receivable management. Factoring is an important source of external financing for corporations and small and medium enterprises (SMEs), which receive credit based on the value of their accounts receivables. Under this form of asset-based finance, the credit provided by a lender is explicitly linked on a formula basis to the value of a borrower’s underlying assets (working capital), not to the borrower’s overall creditworthiness. In developing countries, factoring offers several advantages over other types of lending. First, factoring may be particularly useful in countries with weak secured-lending laws, inefficient bankruptcy systems, and imperfect records of upholding seniority claims, because factored receivables are not part of the estate of a bankrupt SME. Second, in a factoring relationship the credit is primarily based on quality of the underlying accounts, not on the quality of the borrower. Thus, factoring may be especially attractive to high-risk SMEs (Bakker, Klapper, and Udell 2004). The development of OFIs such as leasing and factoring companies (especially if they were operated by groups that were independent of large banks and insurance companies) increases lending to smaller borrowers. Some practitioners argue that stand-alone OFIs tend to compete more vigorously. For that reason, the International Finance Corporation prefers to finance stand-alone leasing companies despite their disadvantage when competing with leasing subsidiaries of commercial banks, which can tap into low-cost depositors’ funding from their parent companies) (International Finance Corporation 1996). While the small size of the OFI sector in some countries may limit OFI’s systemic effect on the rest of the financial sector in case of crisis, stress in OFIs could have systemic effects in specific circumstances. In particular, difficulties in OFIs may have some systemic effect, insofar as they trigger a loss of confidence in deposit-taking activities. For instance, a crisis of confidence can spread from one subsector of the financial system to another subsector, owing to perceived ownership or balance-sheet linkages. Moreover, the lack of effective regulations for OFIs can exacerbate the fragility of the overall financial system through regulatory arbitrage (Herring and Santomero 1999). In many countries, pension funds are a major source of contractual savings, providing a stable source of long-term investment to support growth and at the same time playing a key role in financial markets through their investment behavior. National pension systems provide retirement income from a mixture of government, employment, and individual savings. Pension funds affect the stability of financial markets and the distribution of risks among different sectors of the economy by their investment behavior and the way they manage their risk
Chapter 6:Assessing the Supervision of Other Financial Intermediaries 6.2 Objectives of the Legal and Regulatory Framework for OFls? Against this background,the assessment of the regulation and supervision of OFIs should not only account for their effectiveness in meeting the traditional obiectives of financial supervision,but should also consider whether the regulatory framework helps build a sound environment that fosters the development of those institutions.For instance,an regulatory fra ork that pro rage in the OFI se could restrict the potential developmental role of OFIs and at the same time could lea to the buildup of substantial undetected vulnerabilities and risks While both competition regulation and conduct of business (including market integri- ty)regulation apply to all sectors and institutions in the financial system,assessing which type of OFIs nts prudential regulation is,in practice,a difficult exercise.Three char 6 acteristics an cial ritical nj ing the scope ntia on:the dificulty of honoring the contracttions (b)the dcutyaced the consumer in assessing the creditworthiness or soundness of the institution,and (c)the adversity caused by a breach of contractual obligations(see Carmichael and Pomerleano 2002).For instance,banks are subject to systemic liquidity risks that may lead to the breach of obligations,financial have c mplex s es whose soundnes and creditworthiness are difficult to assess,and the failure of a large bank or company is likely to generate great adversity.Each group of institutions could be ranked using those characteristics to judge the desirability and scope of prudential oversight. An appropriate regulatory environment is required to foster the development of OFIs as recognized legal e ities that are well integrated with the rest of the financial system In ma es,the legal and regulatory fra work for finance,leas and other specialized financial institutions is ambiguous,fragmented,and incomplet Assembling and analyzing the laws and regulations governing the operations of each group of institutions to ensure clarity and completeness is an important step in the assess. ment of OFIs.While repressive regulation can retard the growth of OFIs,an inappropriate and poorly designed r ulatory structure can create incentives for regulatory arbit age However,even hen high-quality l tion exists,enforcement is sometimes poo I hose factors are all impediments to the development of the financial system in general but the impediments become more pronounced in the case of OFls that,in many emerg- ing economies,are often not supported by a clear legal framework. Legislation should permit effective enforcement.The legal framework for financial supervision could be so ewhat prescriptiv spelling specific prudential rules of the governing law,or could be general,th hereby providi ing guideline and principles while conferring broad regulatory powers on the regulator.The guidelines approach could provide more discretion and flexibility to the regulator,which may be particularly important for OFIs,because separate laws governing specific types of OFIs and markers ofe overlap,which gives ris to conficts and ambiguity regarding the onal inde er the effective use of discretion,a more-prescriptive law,if well designed,could provide a workable alternative. 173
173 Chapter 6: Assessing the Supervision of Other Financial Intermediaries 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 6.2 Objectives of the Legal and Regulatory Framework for OFIs2 Against this background, the assessment of the regulation and supervision of OFIs should not only account for their effectiveness in meeting the traditional objectives of financial supervision, but should also consider whether the regulatory framework helps build a sound environment that fosters the development of those institutions. For instance, an inadequate regulatory framework that promotes regulatory arbitrage in the OFI sector could restrict the potential developmental role of OFIs and at the same time could lead to the buildup of substantial undetected vulnerabilities and risks. While both competition regulation and conduct of business (including market integrity) regulation apply to all sectors and institutions in the financial system, assessing which type of OFIs warrants prudential regulation is, in practice, a difficult exercise. Three characteristics of financial institutions are critical in judging the scope of prudential regulation: (a) the difficulty of honoring the contractual obligations, (b) the difficulty faced by the consumer in assessing the creditworthiness or soundness of the institution, and (c) the adversity caused by a breach of contractual obligations (see Carmichael and Pomerleano 2002). For instance, banks are subject to systemic liquidity risks that may lead to the breach of obligations, financial conglomerates have complex structures whose soundness and creditworthiness are difficult to assess, and the failure of a large bank or insurance company is likely to generate great adversity. Each group of institutions could be ranked using those characteristics to judge the desirability and scope of prudential oversight. An appropriate regulatory environment is required to foster the development of OFIs as recognized legal entities that are well integrated with the rest of the financial system. In many emerging economies, the legal and regulatory framework for finance, leasing, and other specialized financial institutions is ambiguous, fragmented, and incomplete. Assembling and analyzing the laws and regulations governing the operations of each group of institutions to ensure clarity and completeness is an important step in the assessment of OFIs. While repressive regulation can retard the growth of OFIs, an inappropriate and poorly designed regulatory structure can create incentives for regulatory arbitrage. However, even when high-quality legislation exists, enforcement is sometimes poor. Those factors are all impediments to the development of the financial system in general, but the impediments become more pronounced in the case of OFIs that, in many emerging economies, are often not supported by a clear legal framework. Legislation should permit effective enforcement. The legal framework for financial system supervision could be somewhat prescriptive, spelling out specific prudential rules within the scope of the governing law, or could be general, thereby providing guidelines and principles while conferring broad regulatory powers on the regulator. The guidelines approach could provide more discretion and flexibility to the regulator, which may be particularly important for OFIs, because separate laws governing specific types of OFIs and markets often overlap, which gives rise to conflicts and ambiguity regarding the applicable rules. If, however, the regulator’s lack of operational independence hampers the effective use of discretion, a more-prescriptive law, if well designed, could provide a workable alternative
Financial Sector Assessment:A Handbook 6.3 Assessing Institutional Structure and Regulatory Arbitrage The appropriateness of the institutional structure for supervising OFIs should conside the overall institutional framework for financial supervision and the scope of the OFIs' activities within that framework.The number and size of OFIs(individual and aggregate), as well as their links to banks and other players in the financial system,are major fac tors infuepcing the appropriate institutional structure for superyising Fls.The stage of financial develor nvironn ent gen and the e of re efor supervising cused on the natur 6 An institutional structure that is sectorally focused rather than fo of functions to be regulated may result in gaps in the regulation of OFIs.In some country circumstances,therefore,bringing the regulation and supervision of all types of financial institutions,including OFIs,under a unified supervisory framework would help reduce the possibilities of regulatory arbitrage and regulatory gaps and allow for more-efficient oversight.A unified structure facilitates the adoption of a common set of standards for institutions with the same of bus profile of risk-for instance,uniform application of conduc ssand financial in gulations, and adi lations ents in th cope of prudential H ever nder structur it an on Ekmocdmfgaoaoadp ory body inv n institu regulation and supervis al atter tion of conflicting areas of jurisdiction,and the extent of regulatory duplication.This sectorally focused structure is a source of inconsistencies and ambiguities that have cre ated weaknesses in the regulatory and supervisory process in many countries.For instance, this structure's inability to undertake"fit-and-proper"tests and impose minimum capital requirements or other specific guidelines creates loose regulatory and supervisory regimes that allow OFIs to develop their business recklessly and get involved in banking activi tie In co separate,se torally focu regulators,the ass ment should focu on ver s of servic providers,since the application of different rules to products and services that are fund tionally equivalent can give rise to increased incentives for regulatory arbitrage (OECD 2002).For instance,institutions assuming the main banking functions should be con- sidered banks and regulated and supervised as such.In some countries.Ofls became an important segment of the financial system as a result of efforts to circumvent prudential norms and exploit loopholes in the banking sector Table 6.1 compares the regulatory featu res of banks and OFIs.Raising the following que stions whe comple table 6 1 ca help regulat i近the dif ces in the rules applied to different group of institutions (Carmichael and Pomerleano 2002) tors by altering its corporation form,regulatory jurisdiction,or institutional label?For example,is a parent institution able to reduce its regulatory burden by shifting business into an unregulated subsidiary? 174
174 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 6.3 Assessing Institutional Structure and Regulatory Arbitrage The appropriateness of the institutional structure for supervising OFIs should consider the overall institutional framework for financial supervision and the scope of the OFIs’ activities within that framework. The number and size of OFIs (individual and aggregate), as well as their links to banks and other players in the financial system, are major factors influencing the appropriate institutional structure for supervising OFIs. The stage of financial development, the legislative environment generally, and the range of regulators’ skills available would also affect the appropriate institutional structure for supervising OFIs. An institutional structure that is sectorally focused rather than focused on the nature of functions to be regulated may result in gaps in the regulation of OFIs. In some country circumstances, therefore, bringing the regulation and supervision of all types of financial institutions, including OFIs, under a unified supervisory framework would help reduce the possibilities of regulatory arbitrage and regulatory gaps and allow for more-efficient oversight. A unified structure facilitates the adoption of a common set of standards for institutions with the same profile of risk—for instance, uniform application of conduct of business and financial integrity regulations, and adjustments in the scope of prudential regulations according to risk profile. However, under a structure with more than one regulatory body involved in institutional regulation and supervision, special attention should be given to the definition of the legal power of responsible bodies, the identification of conflicting areas of jurisdiction, and the extent of regulatory duplication. This sectorally focused structure is a source of inconsistencies and ambiguities that have created weaknesses in the regulatory and supervisory process in many countries. For instance, this structure’s inability to undertake “fit-and-proper” tests and impose minimum capital requirements or other specific guidelines creates loose regulatory and supervisory regimes that allow OFIs to develop their business recklessly and get involved in banking activities. In countries with separate, sectorally focused regulators, the assessment should focus on verifying the differences in the types of risk posed by various categories of service providers, since the application of different rules to products and services that are functionally equivalent can give rise to increased incentives for regulatory arbitrage (OECD 2002). For instance, institutions assuming the main banking functions should be considered banks and regulated and supervised as such. In some countries, OFIs became an important segment of the financial system as a result of efforts to circumvent prudential norms and exploit loopholes in the banking sector. Table 6.1 compares the regulatory features of banks and OFIs. Raising the following four questions when completing table 6.1 can help regulators verify the differences in the rules applied to different group of institutions (Carmichael and Pomerleano 2002): • Can institutions subjected to different regulation provide similar products? • Is a financial institution capable of choosing among different regulators by altering its corporation form, regulatory jurisdiction, or institutional label? For example, is a parent institution able to reduce its regulatory burden by shifting business into an unregulated subsidiary?
Chapter 6:Assessing the Supervision of Other Financial Intermediaries Table 6.1.Main Requlatory and Prudential Aspects of Different Groups of Financial Institutions' Commercial Non-deposit-taking Regulation banks Deposit-taking institutions Main regulator/superviso Restriction on loans Participation in the clearing/settlement system lesulna deoosits Minimum risk weighted capital/asset ratio Liquidity ratio 6 Cash reserve requirements Required provis Limit to a sinale borrower Insider lendinn .Can new OFIs offer banking-type products under a different banner to remain a regulat bility for financial conglomerates? In a unified supervisory structure where the number of OFls is significant but OFl operate independently from the main players in the financial sector (i.e.,banks and insurance companies),establishing a separate department that is exclusively dedicated to the supervision of OFls is a common practice.In such structure,there are cases where the same s are responsible for both onsit supervision and offsit pe vision for a group of OFIs,or cases where there is separation between the responsibility for onsit and offsite functions.On the one hand,having the same regulators be responsible for both onsite and offsite functions helps ensure continuity in monitoring events in the sector,as well as coherence in supervision.On the other hand,separating offsite and onsite func. tions provides a certain degree of specialization in the related pr cesses and procedures.In either case. the skill leve toavoid having inexperien and unqual d regulators ally assigned to supervising OFIs In a unified structure where the links between OFIs and banks are significant through investment and ownership,regulators with responsibility for a group of related institu- tions (including banks and OFls)help monitor development in related sectors in a con solidated manner.Moreover,specialization helps enhance the regulation and supervision of OFIs.Regulators in cha rge o f supervising b they receive adequate training and guidance to specifically deal with OFls.As stresed in the Basel Core Principles(BCPs)for Effective Banking Supervision,an essential element 175
175 Chapter 6: Assessing the Supervision of Other Financial Intermediaries 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 • Can new OFIs offer banking-type products under a different banner to remain outside the jurisdiction of the main regulator? • Is there a regulatory structure in which at least one regulator has overall responsibility for financial conglomerates? In a unified supervisory structure where the number of OFIs is significant but OFIs operate independently from the main players in the financial sector (i.e., banks and insurance companies), establishing a separate department that is exclusively dedicated to the supervision of OFIs is a common practice. In such structure, there are cases where the same regulators are responsible for both onsite supervision and offsite supervision for a group of OFIs, or cases where there is separation between the responsibility for onsite and offsite functions. On the one hand, having the same regulators be responsible for both onsite and offsite functions helps ensure continuity in monitoring events in the sector, as well as coherence in supervision. On the other hand, separating offsite and onsite functions provides a certain degree of specialization in the related processes and procedures. In either case, the regulators’ skill levels should be adequate to avoid having inexperienced and unqualified regulators be systematically assigned to supervising OFIs. In a unified structure where the links between OFIs and banks are significant through investment and ownership, regulators with responsibility for a group of related institutions (including banks and OFIs) help monitor development in related sectors in a consolidated manner. Moreover, specialization helps enhance the regulation and supervision of OFIs. Regulators in charge of supervising banks can usually supervise OFIs, provided they receive adequate training and guidance to specifically deal with OFIs. As stressed in the Basel Core Principles (BCPs) for Effective Banking Supervision, an essential element Table 6.1. Main Regulatory and Prudential Aspects of Different Groups of Financial Institutionsa Regulation Commercial banks Deposit-taking institutions Non-deposit-taking institutions Main regulator/supervisor Restriction on loans Participation in the clearing/settlement system Issuing deposits Subject to onsite supervision Subject to offsite supervision Minimum paid-up capital Minimum risk weighted capital/asset ratio Liquidity ratio Cash reserve requirements Required provisions Limit to a single borrower Insider lending a. This table can be adapted to individual country situations
Financial Sector Assessment:A Handbook consolidated basis,which includes their ability to review both banking and non-banking activities conducted by the bank. 6.4 Assessing Regulatory Practice and Effectiveness The regulatory regime for OFIs should help meet regulatory objectives-effective compe. tition,good conduct of business and financial integrity,and prudent operations- while ensuring that regulations reflect the specific operational characteristics of the OFIs and promote their development.From this many core 6 and als OFIs.The general is that fina anciali tions that general pu do not need to b taking OFIs would follow the standards contained in the BCPs.Financial institutions that are banklike in all but name should also be just as closely regulated and supervised.In several countries,OFIs that were(formally or informally)taking deposits from the general nublic and were either not required to conform to banking regulations or did not come under the supervision of the main supervisory authority have faced difficulties that neces- sitated the intervention of the gove ment(World Bank 1999). nthe dive tha of institutions of OFIs ertain additional principles and sid ions can comp he nd he pt them to the supervision of OFls.Such principles and considerations.regardles of the institution structure (unified or segmented),include modifying prudential rules to accommodate the operational characteristics of OFls;ensuring consistency in decision making:recognizing the unique risks of OFI;ensuring that supervision is proportionate and consistent with costs and benefits;and maintaining resources and skills sufficient and adequate to face the mplementation can be challe ge.For example ing fin stitutions, offer depo y checking accounts)and may need to ted as ba g institutions(se operational cha acteristicso the OFIs and avoiding overregulation is important for the development of the sector For the majority of OFIs where retail deposits and systemic issues are not involved, competition and market conduct regulations-such as entry and disclosure requirements and monitoring association with other institutions-should be sufficient.With regard to entry requirements.the regulator would encourage low barriers to entry into these sec tors by ensuring that there are minimal restrictionson the corporate form and ownership structure of OFIs,freedom of e ry for for ign firms and st ondit prevent exce tion in the industry.Disclo nd tim mation to ma arket participants comp ments supervisio Regarding th OFls with other institutions,particular attention should be given to OFIs establis as subsidiaries of regulated institutions as a means of circumventing the regulation.The dangers of excessive growth in unregulated subsidiaries were highlighted in a number of crises (see World Bank 2001)
176 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 of banking supervision is regulators’ ability to supervise the banking organization on a consolidated basis, which includes their ability to review both banking and non-banking activities conducted by the bank. 6.4 Assessing Regulatory Practice and Effectiveness The regulatory regime for OFIs should help meet regulatory objectives—effective competition, good conduct of business and financial integrity, and prudent operations—while ensuring that regulations reflect the specific operational characteristics of the OFIs and promote their development. From this perspective, many core principles of effective bank supervision and regulation also apply to OFIs. The general rule is that financial institutions that do not have deposit-like liabilities to the general public do not need to be regulated and supervised as closely as those that do. The tools and techniques for deposittaking OFIs would follow the standards contained in the BCPs. Financial institutions that are banklike in all but name should also be just as closely regulated and supervised. In several countries, OFIs that were (formally or informally) taking deposits from the general public and were either not required to conform to banking regulations or did not come under the supervision of the main supervisory authority have faced difficulties that necessitated the intervention of the government (World Bank 1999). Given the diversity of institutions that make up the group of OFIs, certain additional principles and considerations can complement the BCPs and help adapt them to the supervision of OFIs. Such principles and considerations, regardless of the institutional structure (unified or segmented), include modifying prudential rules to accommodate the operational characteristics of OFIs; ensuring consistency in decision making; recognizing the unique risks of OFI; ensuring that supervision is proportionate and consistent with costs and benefits; and maintaining resources and skills sufficient and adequate to face the growth of the OFIs sector. Those principles are similar to those applying to banks, and are further explained in Annex 6.A. Their implementation can be a challenge. For example, housing finance institutions, including building societies, often offer deposit services (not necessarily checking accounts) and may need to be regulated as banking institutions (see box 6.1). In many cases, tailoring regulations to the specific operational characteristics of the OFIs and avoiding overregulation is important for the development of the sector. For the majority of OFIs where retail deposits and systemic issues are not involved, competition and market conduct regulations—such as entry and disclosure requirements and monitoring association with other institutions—should be sufficient. With regard to entry requirements, the regulator would encourage low barriers to entry into these sectors by ensuring that there are minimal restrictions on the corporate form and ownership structure of OFIs, freedom of entry for foreign firms, and strong antitrust conditions to prevent excessive concentration in the industry. Disclosure of correct and timely information to market participants complements supervision.3 Regarding the association of OFIs with other institutions, particular attention should be given to OFIs established as subsidiaries of regulated institutions as a means of circumventing the regulation. The dangers of excessive growth in unregulated subsidiaries were highlighted in a number of crises (see World Bank 2001)
Chapter 6:Assessing the Supervision of Other Financial Intermediaries Box 6.1 The Case of Financial Institutions Providing Housing Finance ing banks and other specialized banks,which have more diversified balance sheets itutio there is eve a case for stricter regulation of thos often offer the sam estate finance means that their risks may be highl ee the ntr ted,and a large short-term funding,and market risk at the time of wever,in securiries market may help those institutions man onditions under which deposits can be with- their risk profile and minimize the concentration of eintitutionsaecftennentionel 141 housing finance institutions and are viewed as justi- hich an very similar to banks in terms of the range of finan 6 enttal rule cial services offe are grouped together wit sing fin other not on n th be regulated with standards smilar to those ofk must be regulated at the hete rogeneity of other financi nd institutions are sometimes greater than those of ing housing finance. When corporate laws are still evolving,however,additional conditions in financial regulation car pport the good market conduct and prudent operation of OFls.Those additional conditions could cover the following 。Licens ng requirements.As with any financial institution,the purpose of licens ing OFls should be to ensure adequate capitalization and sound management not to limit entry or restrict competition.Regulators should have the authority to screen potential owners and managers to prevent those lacking professional ense should not come a simple alternative fo applicant who could no meet the requirements to be granted a commercial bank license.Liberal entry into the financial system should not mean unqualified entry.Countries with easy entry have often experienced problems with insufficiently regulated,undercapitalized and poorly managed institutions In s ne count ies once an OFI has been licensed,it conducts activities thatar normally not permissible under the range of activities specified in its license.The balance sheet restrictions for each group of financial institution should,therefore be closely monitored (e.g.,limits on assets and liabilities,prohibition on particular classes of assets or liabilities,restrictions on the types of assets held,and mandated of parti mum capital requirements. Vith regard tominimum capital requirements (and all the main rules for the conduct of the institution),the requirements for banks 177
177 Chapter 6: Assessing the Supervision of Other Financial Intermediaries 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 When corporate laws are still evolving, however, additional conditions in financial regulation can support the good market conduct and prudent operation of OFIs. Those additional conditions could cover the following: • Licensing requirements. As with any financial institution, the purpose of licensing OFIs should be to ensure adequate capitalization and sound management, not to limit entry or restrict competition. Regulators should have the authority to screen potential owners and managers to prevent those lacking professional qualifications, financial backing, or moral standing from obtaining a license. An OFI license should not become a simple alternative for applicants who could not meet the requirements to be granted a commercial bank license. Liberal entry into the financial system should not mean unqualified entry. Countries with easy entry have often experienced problems with insufficiently regulated, undercapitalized, and poorly managed institutions. In some countries, once an OFI has been licensed, it conducts activities that are normally not permissible under the range of activities specified in its license. The balance sheet restrictions for each group of financial institution should, therefore, be closely monitored (e.g., limits on assets and liabilities, prohibition on particular classes of assets or liabilities, restrictions on the types of assets held, and mandated maximum or minimum holdings of particular assets). • Minimum capital requirements. With regard to minimum capital requirements (and all the main rules for the conduct of the institution), the requirements for banks Box 6.1 The Case of Financial Institutions Providing Housing Finance In the housing sector, banks and other specialized financial institutions such as thrifts, mortgage societies, primary mortgage institutions, or mortgage banks often offer the same products. Those institutions face similar risks, including credit risk exposure to the borrowers, liquidity risk from the possible loss of short-term funding, and market risk at the time of maturity. The conditions under which deposits can be withdrawn from those institutions are often mentioned as differentiating factors between banks and specialized housing finance institutions and are viewed as justification to impose different prudential rules (such as on liquidity). The general rule, however, is that when specialized housing finance institutions solicit deposits directly from the public and when those institutions’ deposits are guaranteed implicitly or explicitly by the government, those institutions must be regulated at least to the standards of banks. Given that the risks of specialized housing finance institutions are sometimes greater than those of banks, which have more diversified balance sheets, there is even a case for stricter regulation of those institutions. The concentration in housing and real estate finance means that their risks may be highly concentrated, and a large overconcentration can be the source of systemic failures. However, in some countries, the availability of a mortgage-backed securities market may help those institutions manage their risk profile and minimize the concentration of exposures. In some countries, building societies—which are very similar to banks in terms of the range of financial services offered—are grouped together with other nonbank financial institutions (NBFIs) and are supervised separately, even though they need to be regulated with standards similar to those of banks. More generally, the heterogeneity of other financial institutions often results in inappropriate regulation and supervision of some financial institutions providing housing finance
Financial Sector Assessment:A Handbook should not be applied to OFIs when not adequately justified.The minimum capita requirement is usually part of the financial institution's licensing requirements,but should not inhibit the start-up of new institutions or act as barrier to competition. The amount of capital appropriate for a group of OFIs or an individual institution is a function of the institution's potential to incur unexpected losses.A higher than 。 ary limit could restrict the industry's growth. ccountability requir ents includ ing accounting and auditing practices by OFIs,are inadequate. his deficiency increases the chance that misleading information could cause market instability Facilitating market discipline and sound practices for accounting and auditing helps reinforce supervisory efforts to encourage OFIs to maintain sound risk man- 6 g nent practices s and internal controls.As with any financial institution,OFIs sour standards o achie e nspa other use of that information to make an accurate assessment of the institution's financial condition and performance,its business activities,and the risks related to those activities 。 Risk management practices commensurate with the risk profile in the industry.Measuring monitoring,a trolling risks are often issues of oncern with ofls especially countries vhere censes were granted too .It is important that the OFl put in place a risk management process adequare for the size and the patur of its activities.Regulators should ensure that such a risk management system is not static,but rather adjusted to the OFI's risk profile (concentration,credit,cur- rency,or tax-related risks).This process is not only helpful in identifying potential also in setting priorities for allocation of limited up capacity,for instance,to determin the fr equency of reporting and the depth and focus of onsite supervision. Building supervisory capacity does not mean that all OFIs need to be supervised,and when they do,they usually do not require the same level of supervision and resources as banks.The supervisory authority must establish priorities for the allocation of regulators' supervisory capacity.There is sometimes little benefit in trying to regularly visit small, dispersed OFIs that,with modest cha nge in regulation (e.g.,lic ing,and disclosure requirements), could capital egligible risk After establishing supervisory priorities,regulators should aso ensure that OFl (particularly small non-deposit-taking institutions)are not overwhelmed by excessive reporting requirements when they do not present major variations in their portfolios from one period to the other.In most cases,quarterly or even semiannual returns (instead of monthly retums)would be appropriate.For those institutions accuracy and completeness mportant than requency.At the e,mo should be given to OFIs with sul ial assets whose reporting should be more frequent. Other recurrent issues relate to the following: .Deficiencies with offsite supervision,which weaken early wamning systems to iden- tify weak OFIs 178
178 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 should not be applied to OFIs when not adequately justified. The minimum capital requirement is usually part of the financial institution’s licensing requirements, but should not inhibit the start-up of new institutions or act as barrier to competition. The amount of capital appropriate for a group of OFIs or an individual institution is a function of the institution’s potential to incur unexpected losses. A higher than necessary limit could restrict the industry’s growth. • Accountability requirements. In many countries, accountability requirements, including accounting and auditing practices by OFIs, are inadequate.4 This deficiency increases the chance that misleading information could cause market instability. Facilitating market discipline and sound practices for accounting and auditing helps reinforce supervisory efforts to encourage OFIs to maintain sound risk management practices and internal controls. As with any financial institution, OFIs need sound accounting standards to achieve satisfactory transparency—public disclosure of reliable information that enables market participants and other users of that information to make an accurate assessment of the institution’s financial condition and performance, its business activities, and the risks related to those activities. • Risk management practices commensurate with the risk profile in the industry. Measuring, monitoring, and controlling risks are often issues of concern with OFIs, especially in countries where licenses were granted too liberally. It is important that the OFI put in place a risk management process adequate for the size and the nature of its activities. Regulators should ensure that such a risk management system is not static, but rather adjusted to the OFI’s risk profile (concentration, credit, currency, or tax-related risks). This process is not only helpful in identifying potential systemically important OFIs, but also in setting priorities for allocation of limited supervisory capacity, for instance, to determine the frequency of reporting and the depth and focus of onsite supervision. Building supervisory capacity does not mean that all OFIs need to be supervised, and when they do, they usually do not require the same level of supervision and resources as banks. The supervisory authority must establish priorities for the allocation of regulators’ supervisory capacity. There is sometimes little benefit in trying to regularly visit small, dispersed OFIs that, with modest change in regulation (e.g., licensing, minimum capital, accounting, auditing, and disclosure requirements), could present negligible risk. After establishing supervisory priorities, regulators should also ensure that OFIs (particularly small non–deposit-taking institutions) are not overwhelmed by excessive reporting requirements when they do not present major variations in their portfolios from one period to the other. In most cases, quarterly or even semiannual returns (instead of monthly returns) would be appropriate. For those institutions accuracy and completeness are far more important than frequency. At the same time, more attention should be given to OFIs with substantial assets whose reporting should be more frequent. Other recurrent issues relate to the following: • Deficiencies with offsite supervision, which weaken early warning systems to identify weak OFIs
Chapter 6:Assessing the Supervision of Other Financial Intermediaries .Unreliable and rudimentary working methods,which pr vent regulators fron ingtheF're,for th nnd financ Theack of interal guidelines or manual for onite and offite supervision,which are important to determine the examination procedures and policies for OFIs An adequate information system and a guideline or manual are useful tools to help address the specific risks inherent to OFls. 6.5 Selected Issues on the Regulation and Supervision of Leasing Companies 6 In some circumstances,a separate legal and regulatory framework for leasing companies can be helpful to create a suitable environment for leasing and promote confidence in the industry.Many developed countries,despite their long history of leasing,do not have ng law (An and Ru 2000).Tho lly have common and civil l s that pro e an adequat sis to support leasing transactions.In coun nes whe re the leasing industry is st n the very earl stages o levelopment,a new legal and regulatory framework could help promote confidence in the efficiency and fairness of the market.Specialized leasing laws may not be necessary however,provided that existing regulations designed to deal with financial institutions do not discriminate against the industry.When the industry develops,however,it will be important that the fundamental elements of an efficient financial leasing law be put in place.Those elements include the following(see International Finance Corporation 1998): Freedom of contract ee-party s structure of the modem financial lease Lessee's dut ty to pay after acceptan Lessor's lack of equipment t responsibilities Lessee's recourse against the seller Equipment not liable to other creditor's claims Transfer freedom and restraint .Default remedies,including the right to accelerate the remaining lease payments .Expedient repossession and recovery The rights and duties of the lessor as legal owner of the asset and the rights and duties of the lessee as user of the asset should be clearly stated.The legal owner needs a clear simple,workable,timely process to reclaim asset if the terms of the lease are breached by the e,including the s and the omatic right of and other d on without paym due mus ave the right to use the asset unimpeded and gain the full productivity oft he asset.In some coun tries,it may be necessary to clarify that the lessee does not have the right to create a lien on leased assets(International Finance Corporation 1996).One advantage of the leasing 179
179 Chapter 6: Assessing the Supervision of Other Financial Intermediaries 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 • Unreliable and rudimentary working methods, which prevent regulators from efficiently and accurately assessing the OFI’s exposure to various risks and, for the most part, its soundness and financial performance • The lack of internal guidelines or manual for onsite and offsite supervision, which are important to determine the examination procedures and policies for OFIs An adequate information system and a guideline or manual are useful tools to help address the specific risks inherent to OFIs. 6.5 Selected Issues on the Regulation and Supervision of Leasing Companies In some circumstances, a separate legal and regulatory framework for leasing companies can be helpful to create a suitable environment for leasing and promote confidence in the industry. Many developed countries, despite their long history of leasing, do not have a separate leasing law (Amembal, Lowder, and Ruga 2000). Those countries usually have well-developed common and civil laws that provide an adequate basis to support leasing transactions. In countries where the leasing industry is still in the very early stages of development, a new legal and regulatory framework could help promote confidence in the efficiency and fairness of the market. Specialized leasing laws may not be necessary, however, provided that existing regulations designed to deal with financial institutions do not discriminate against the industry.5 When the industry develops, however, it will be important that the fundamental elements of an efficient financial leasing law be put in place. Those elements include the following (see International Finance Corporation 1998): • Freedom of contract • Recognition of the three-party structure of the modern financial lease • Duties consistent with party’s role in the transaction − Lessee’s duty to pay after acceptance − Lessor’s lack of equipment responsibilities − Lessee’s recourse against the seller − Equipment not liable to other creditor’s claims − Transfer freedom and restraint • Default remedies, including the right to accelerate the remaining lease payments • Expedient repossession and recovery The rights and duties of the lessor as legal owner of the asset and the rights and duties of the lessee as user of the asset should be clearly stated. The legal owner needs a clear, simple, workable, timely process to reclaim an asset if the terms of the lease are breached by the user, including the automatic right of repossession without lengthy court proceedings and the right to claim payments due and other damages. The lessee must have the right to use the asset unimpeded and gain the full productivity of the asset. In some countries, it may be necessary to clarify that the lessee does not have the right to create a lien on leased assets (International Finance Corporation 1996). One advantage of the leasing
Financial Sector Assessment:A Handbook Box 6.2 Measures to Develop a Favorable Requlatory Environment for Leasing Legal Framework Prudential.Regulations may have ership.Ownership should be clearl n man uninte the leas period if Tax Treatment ease payments are curren .Lessor.The lessor should be allowed to depre Regulations ciate the ct,with lease payments taxed a 6 ife shoter than should h wed to trea aries to write leasing mobilize term deposits only. nancing. companies over banks is that they own the leased asset.However,physical repossession can still prove difficult.For instance.the mobility of the leased asset has made reposses. sion even more difficult.In its lessons of experience,International Finance Corporation (1996)has identified a set of measures to develop a favorable regulatory environment for leasing (box 6.2). ever,m any leasing companies are bank es, and regu lators hould be interested in such companies for the purpose of consolidated supervi sion.Moreover,as previously stated,even for NBFls where retail deposits and systemi issues are not involved and where corporate laws are still evolving,additional condi tions-including licensing requirements,minimum capital requirements,accountability requirements,and risk conditions consistent with the risk involved in the industry-can support market conduct. 6.6 Selected Issues on the Regulation and Supervision of Factoring Companies of account receivables,then it will pay the firm a prenegotiated,discounted amount of the face value of the invoices (Sopranzetti 1998).A moral hazard problem develops when the seller's credit management efforts are unobservable to the factoring company:Once the entire 180
180 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 companies over banks is that they own the leased asset. However, physical repossession can still prove difficult. For instance, the mobility of the leased asset has made repossession even more difficult. In its lessons of experience, International Finance Corporation (1996) has identified a set of measures to develop a favorable regulatory environment for leasing (box 6.2). In many countries, leasing companies are not regulated and supervised because they do not take deposits. However, many leasing companies are bank subsidiaries, and regulators should be interested in such companies for the purpose of consolidated supervision. Moreover, as previously stated, even for NBFIs where retail deposits and systemic issues are not involved and where corporate laws are still evolving, additional conditions—including licensing requirements, minimum capital requirements, accountability requirements, and risk conditions consistent with the risk involved in the industry—can support market conduct. 6.6 Selected Issues on the Regulation and Supervision of Factoring Companies Factoring companies are financial institutions that specialize in the business of accounts receivable financing and management. If a factoring company chooses to purchase a firm’s receivables, then it will pay the firm a prenegotiated, discounted amount of the face value of the invoices (Sopranzetti 1998). A moral hazard problem develops when the seller’s credit management efforts are unobservable to the factoring company: Once the entire Box 6.2 Measures to Develop a Favorable Regulatory Environment for Leasing Legal Framework • Lessor’s ownership. Ownership should be clearly stated, with simple, effective, and timely procedures for repossession if lessee defaults. • Lessee’s rights. Rights should be clear—uninterrupted use of leased asset for the lease period if the lease payments are current. Regulations • Licensing. Regulation should recognize the existence of leasing. Restricting leasing to licensed institutions (and requiring commercial banks to set up separate subsidiaries to write leasing contracts) may help the industry develop aggressively. Leasing companies should be allowed to mobilize term deposits only. • Prudential requirements. Regulations may have lower minimum capital requirements than many other financial institutions. Other prudential requirements may be less strict than for deposittaking institutions. Tax Treatment • Lessor. The lessor should be allowed to depreciate the asset, with lease payments taxed as income and asset depreciation computed over life shorter than or equal to lease contract. • Lessee. The lessee should be allowed to treat lease payments as an expense for tax purposes. • Sales tax. The postcontract sale of the asset should be exempt from sales tax. • Capital allowances. Allowances should be given to lessor or lessee, with equal treatment compared to other financing. Source: International Finance Corporation (1996)