NON-BANK FINANCIAL INSTITUTIONS: Backup Facilities?

NON-BANK FINANCIAL INSTITUTIONS: Backup Facilities?

”What we perceived in the United States in 1998 may reflect an important general principle: Multiple alternatives to transform an economy’s savings into capital investment act as backup facilities should the primary form of intermediation fail. In 1998 in the United States, banking replaced the capital markets. Far more often it has been the other way around, as it was most recently in the United Sates a decade ago.”

(Alan Greenspan: 1999)

Question: Do we agree with his statement?

Theoretical Background

Definition

Non-Bank Financial Institution (NBFI) are institutions other than banks that offer financial services (FFIEC: 2012).

Services Offered by NBFI

Main services offered by Non-Bank Financial Institutions are:

• 1.      Payments

Some financial institutions provide payments services by issuing claims that have the capacity to be used in settling transactions.

• 2.      Liquidity/credit

Several NBFIs enhance the ability to generate asset’s full market value that can be realized once the decision to sell that asset has been made. An example can be taken from pawn shop.

• 3.      Divisibility

NBFIs break up large denomination and aggregate small denomination. An asset can be traded in small denominations. An example can be taken from mutual funds.

• 4.      Store of value

This service focused on the extent to which an asset provides a reliable store of purchasing power over time. This is related with saving preferences. Saving money in NBFIs in the current year, customers expect to receive a sum of money in the future with the same or higher future purchasing power compared to the current purchasing power.

• 5.      Information

NBFIs support society by process information and assess the risks.

• 6.      Risk pooling

NBFIs offer lower risk to investors.

Many NBFIs provide services that are also provided by banks, that is why the distincition between both types are not crystal clear. However, NBFIs and banks have distinctive characteristic. NBFIs are usually possessed by conglomerates (as the case in Korea which will be described further in the next section), while banks are usually possessed by state or government. Several resources also mentioned that banks are allowed to take demand deposits, while non-bank financial institutions are not (Sufian: 2006, World Bank: 2005)

World-wide Cases                                                                                 

UNITED STATES

During 1990-1991, United States faced another recession. Recession is argued to be a natural part of US business cycle which consists of peak, recovery and expansion (Kamery: 2004). Recession during this period was due to the natural response of expansion (Dunnan and Pack: 1991). During the expansion, economy goes pretty well that triggers the intention of consumers and corporations to borrow fund. Due to the rising demand of borrowings, the interest rates rises. During the expansion period, the rising demand also causes the rise in prices for goods and services, especially houses. These conditions lead to the decreasing demand of borrowings and plummeting spending. The outcomes from too high expansion causes the reveral of the expansion itself. Since the contraction in economy lasted long enough, the economy could be labeled a recession (Kamery: 2004).

The detailed explanations about the conditions causing the recession are depicted in the following figure:

(Source: Mankiw and Ball: 2010)

Recessions such as US recession during 1990-1991 gave severe impacts for financial instituions, especially banks. Banks loses revenue because a recession reduces the demand for loans. Firm get bankrupt and te loan defaults rises. These problems trigger fear of the bank in lending the customers as well (Mankiw and Ball: 2010). 

There are several argument stating that the existence of non-bank financial institutions has helped United States to avoid more severe recession in 1990-1991. When American banks stopped lending during the recession period, the value of real estate collateral also collapse. However, US capital markets were able to substitute for the loss of US banks. Recently developed mortgage-backed securities market kept residential mortgage credit flowing, which would have contracted severely in prior years (Greenspan: 1999). It was even argued that US could have faced more worse recession if the situation is bank based rather than market based (the market is concentrating on banks only, with little and immaterial amount of NBFIs).

Mild recession in US in 1991 is much less sever that the long-lasting problems in Japan and most East Asia countries whose financial system is bank-based. Banks as dominant source of funding in Japan did not possess sufficient power to aver the credit crunch. However, there are no statement that bank-based countries had the same story as Japan. Continental Europe, such as Germany had different story. Most Continental Europe countries were able to escape from the turmoil in the beginning of 1990s because they design proper regulations for banks and other financial institutions.

KOREA: the Financial Sector Liberalization

Gradual liberalization for domestic financial sector has been started in the early 1980s in Korea. As the entry into commercial banking was liberalized, entry barriers for non-bank financial institutions were also lowered. This condition triggered excessive establishment of new financial institutions. However, this condition was also not accompanied by a proper set of supervisions and regulations from the government. Korea system regulated that commercial banks there are under the direct authority of the Bank of Korea’s Office of Banking Supervision while non-bank financial institutions are under Ministry of Finance and Economy. Weak supervision for NBFIs by the MOFE in that era has created opportunities for regulatory arbitrage and lead NBFIs to risky practices.

One critical problem related with Non-Bank Financial Institutions is the rapid expansion of virtually unregulated merchant banks into area generally dominated by banks. The population of NBFI in korea during that era was rather significant, accounting for approximately 30% of financial system assets. These institutions consisted of three main types which are investment institutions, savings institutions and insurance companies. Investment insitutions such as merchant banks, investment trust companies and securities companies play most important role since they possess the largest segment in terms of assets.

Most of investments trust companies were owned by chaebol groups (conglomerates). The regulation indicated that merchant banks were supposed to be supervised by the MOFE. However, supervision was actually minimal. There were not regulations concerning the assets classifications, capital, even the standard practices such as consolidated accounting and market value accounting. Since these merchant banks were related to the chaebol groups, they were used by the chaebol groups to provide funds for them. This condition non only reduced the transparency and market dicipline in raising funds from the public, but also increase the leverage of the corporate sector.

(Source: IMF Working Paper The Korean Financial Crisis of 1997- A Strategy of Financial Sector: 1999 and Carmichael and Pomerleano: 2002)

DISCUSSIONS

Supporting Arguments

The opinion of Alan Greenspan (1999) suggesting that multiple source of finance help to protect economies against systemic problems affecting financial markets are also supported by several evidence and facts. Davis (2001) provides evidence showing that the existence of active securities markets alongside banks is indeed beneficial to the stability of corporate financing, both during cyclical downturns and during financial crisis.

By providing additional and alternative financial services, NBFIs improve general system-wide access to finance. They also help to facilitate longer-term investments and financing, which is often a challenge in the early stages of bank-oriented financial sector development. The growth of contractual/collective savings institutions such as insurance companies, pension funds, and mutual funds widens the range of products available for people and companies with resources to invest. These institutions also provide competition for bank deposits, thereby mobilizing long-term funds necessary for the development of equity and corporate debt markets, municipal bond markets, infrastructure finance, mortgage bond markets, leasing, factoring and venture capital (World Bank: 2006).

Collective savings institutions also allow for better risk management, while helping to reduce the potential for systemic risk through the aggregation of resources, allocation of risk to those more willing to bear it, and application of portfolio management techniques that spread risk across diversified parts of the financial system.

There are several points that highlight the importance of NOBFIs: (Carmichael and Pomerleano: 2002)

• 1.      NBFIs complement banks by providing services that are not well-suited to banks.

• 2.      NBFIs provide competition for banks in the provision of financial services

• 3.      NBFIs specialize in particular sector and target particular group that enable them to enjoy advantages arising from specialization.

The role of Non-Bank Financial Statements in Indonesia

Based on World Bank (2006), up to the current decade, financial institutions in Indonesia are dominated by non-bank financial institutions. NBFIs in Indonesia are much smaller than those in several other large developing countries and in many countries of the East Asia region. In line with the economy-wide shift towards longer term development agendas and emerging development priorities, strengthening NBFIs is now an urgent policy.

Indonesia needs the long-term domestic resources that can be mobilized by NBFIs ,these can be used to finance productive investments, especially infrastructure. This provides a window of opportunity for much needed reforms. While this is an excellent start, more challenges lie ahead on the path to comprehensive reform and strengthening of NBFIs. While each sub-sector has its own specific issues, there are also some common problems across sub-sectors.

Based on the arguments stated previously, I support the statement of Alan Greenspan that non-bank financial institutions are need as back up facilities.

However, learning from the history in Korea, these non-bank financial institutions must be accompanied by proper regulations so that those financial institutions follow good corporate governance.

REFERENCES

Carmichael, Jeffrey, and Michael Pomerleano. Development and Regulation of Non-Bank Financial Institutions. World Bank Publications, 2002, 12.

FFIEC (Federal Financial Institutions Examination Council Bank Secrecy Act/Anti-Money Laundering), 2012, as downloaded from http://www.ffiec.gov/bsa_aml infobase/pages_manual/olm_091.htm.

Feng, W. 2007. The Disinctive Characteristics of Life Insurance Operation. Presentation. As donwloaded from http://www.e-chinalife.com/IRchannel/files/China% 20Life%20Corporate% 20Day%20Presentations-4.pdf

Kamery, R.H. 2004. A Brief Review of the Recession of 1990-1991. Proceedings of the Academy of Legal, Ethical and Regulatory Issues. As downloaded from http: //www.sbaer.uca.edu/research/allied/2004_maui/legal_ethical_regulatory_issues/14.pdf.

Greenspan, A. 1999. Remarks by Chairman Alan Greenspan: Do Efficient Financial Markets Mitigate Financial Crises? As downloaded from:  http:// www.federalreserve.gov/boarddocs/speeches/1999/19991019.htm.

Sufian, F. 2006. The Efficiency of Non-Bank Financial Institutions: Empirical Evidence from Malaysia. International Research Journal of Finance and Economics Issue 6 (2006). As downloaded from: http://www.eurojournals.com/irjfe%206%2 0fadzlan.pdf.

World Bank. 2006. Unlocking Indonesia’s Domestic Financial Resources: The Role of Non-Bank Institutions. As downloaded from:

Note: this material is partially taken from my last assignment on Bank and Other Financial Institutions class.