Financial Sector Assessment

Large and Complex Financial Institutions16

The activities of large and complex financial institutions (LCFIs)17 raise issues of cross­sectoral and cross-border transfer of financial risks that are especially relevant to a com­prehensive assessment of the strengths and weaknesses of financial systems and their supervision. An LCFI is likely to have the following characteristics:

• An LCFI will be an important player in both wholesale and retail financial markets and in substantial international operations, regionally or globally. In some cases, these operations could dwarf its business in the country under consideration.

• The group may have its headquarters in the country or may be based abroad. In the latter case, it will have a significant local presence in the form of branches or locally incorporated subsidiaries (perhaps including local holding companies). The legal form of its local presence may have important implications for the way it is regulated.18

• The group’s international and domestic business will span a number of financial activities including commercial banking and other lending, such as the origination and securitization of credit; securities trading, dealing and underwriting, mergers and acquisitions, and other capital market activity; life and general (property and casualty) insurance; and custody and asset management. In some cases, the opera­tions of the wider group may include significant industrial and other nonfinancial activities.

• The group is likely to be prominent in the local payments, clearing, and settle­ments structure.

As a consequence of the characteristics of an LCFI, the group’s liabilities will reflect very diverse sources of local and cross-border funding and reserves, while its assets will include a full range of marketable and nonmarketable financial instruments held locally and abroad. Off-balance sheet items are likely to be particularly prominent and to reflect complex funding, plus hedging and speculative trading strategies, all of which are carried out in both over-the-counter (OTC) markets and on organized exchanges. The group is likely to comprise many different legal entities, and the link between those entities and

its internal management structure may appear complicated or even opaque. Complexity or opaqueness in organizational structures could be a potential source of risk, as well as raising issues for supervisory and central bank coordination.

The group’s activities may be subject to numerous different national legal and insol­vency, accounting, tax, and regulatory regimes, which will influence the management of its business and balance sheet. The group may or may not have an overall lead supervisor monitoring its activities on a consolidated basis. At the host country level, responsibility for supervision of an LCFI’s local affiliates may reside within a single regulator or several functional regulators. The size of the group and of its geographical diversification has the potential to threaten financial stability in several countries and markets. Its operations will thus be of concern both to its many financial regulators and also to the central banks and guarantee agencies that could be involved in providing or facilitating liquidity or other official financial support.

The presence of foreign-owned LCFIs in the domestic financial market may not raise particular issues for local financial stability, when their share of local banking, securities, and insurance markets is small and when the nature of their local business is straightfor­ward. While local and foreign affiliates of wider LCFI groups may well be counterparties in foreign exchange and OTC derivatives transactions of local financial institutions, this need not warrant any special analysis, absent any significant concentrations of exposure. Conversely, there may be cases where an internationally active institution has such a large share of the local market or is such a significant counterparty of local financial institu­tions that its failure could constitute a serious local systemic risk. In such instances of high concentration, an understanding of the wider operations of the group, its reputation, and the risks of its business should be important in assessing potential threats to financial stability.

In relation to LCFIs, there are clearly limits to the scope of assessments at the level of individual countries. Country assessments can be expected to cover only part of the activities of LCFIs, given the international nature of such. Even if local supervision of an LCFI is effective in identifying and mitigating local risks as far as possible and if there is good cooperation with the LCFI’s home regulator(s), a host country is unlikely fully to escape the effects of a failure. The assessment process should focus mainly on those aspects over which the countries’ authorities can reasonably be expected to exert an influence.

An examination of LCFIs can be approached in three stages, followed by a summary of the main risks identified and recommendations to the authorities:

• Stage I involves the identification of the scope and scale of LCFIs’ activities within the local financial system. An assessor will want to seek data on market shares of prominent, internationally active, financial institutions to determine if a focus on LCFI activities is warranted. Where one or more LCFIs have been identified as having particular significance for local systemic stability, more detailed firm - specific information on the legal entity and organizational structures, the nature of intra-group exposures, the main sources of earnings, and so forth may then be needed to provide a sufficiently detailed map of their activities to identify the main channels of systemic risk. For some internationally prominent LCFIs, it may

be possible to draw on information gathered from other assessments conducted for other countries.

• Stage II involves an assessment of the major systemic risks arising from the activi­ties of LCFIs. Emphasis should be placed on the extent and nature of both intra­group transactions and the exposures of other domestic institutions to LCFIs. Key concerns will be not only potential direct losses in the event of an LCFI failure but also contagion risks. The approach suggested here is that this assessment be built up by considering credit, technical,19 liquidity, market, and operational risks from the different businesses of the group. LCFIs’ participation in local payment and settlement systems should also form a significant part of the analysis. Drawing on the preceding qualitative identification of risks, the assessor may also want to quantify the risks by considering further stress testing or scenario analyses.

• Stage III involves an assessment of the effectiveness of the authorities’ policies and practices in addressing the risks. This stage should include a review of group capital adequacy, the regulation of large exposures and of intra-group transactions, and the extent and effectiveness of information sharing between local and foreign supervisors. Oversight of the role of LCFIs in local payment and settlement systems should also be considered.

Given the potential of LCFIs to be a conduit in the transmission of internal and external shocks, the authorities’ approach to surveillance—the identification of potential systemic risks from the activities of LCFIs—should be a prominent part of the assessment. The assessment team may want to assess the effectiveness of stress testing and scenario analyses that are conducted by the authorities and that may be complemented by work conducted by the team itself as part of Stage II. The state of preparedness for managing a crisis arising from a domestically headquartered LCFI that is in difficulties or from the failure of a major foreign, internationally active institution that threatens local financial stability is an important issue for supervisors to consider.