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:
Some
financial institutions provide payments services by issuing claims that have
the capacity to be used in settling transactions.
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.
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.
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.
NBFIs
support society by process information and assess the risks.
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.
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.
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.
