Regulators Must Understand Consolidation Risks

By James Hamilton, J.D., LL.M., Senior Writer Analyst, CCH Federal Securities Law Reporter; Co-Author, CCH Federal Privacy Rules for Financial Institutions and Financial Services Modernization - Gramm-Leach-Bliley Act of 1999 - Law and Explanation; contributing author, CCH FOCUS.

s financial consolidation increases, Federal Reserve Board Vice Chairman Roger W. Ferguson Jr. believes it is imperative for regulators to obtain a clear understanding of the risks involved in this trend. In remarks at the Eleventh Annual Hyman P. Minsky Conference on Financial Structure held at Annandale-on-Hudson, New York, the central banker emphasized that financial consolidation can affect the risks to both individual financial institutions and the financial system as a whole. While existing policies appear adequate to contain individual firm and systemic risks now and in the intermediate term, future needs demand that several topics be accorded careful attention.

The potential impact of financial consolidation on the risk of individual financial institutions is mixed and the net result is impossible to generalize, Ferguson remarked. Consolidation seems most likely to reduce risk through diversification gains, he noted, but even here the possibilities are complex. While diversification gains seem likely following consolidation, some firms shift toward riskier asset portfolios and consolidation may increase operating risks and managerial complexities for those firms.

Because the net impact of consolidation on individual firm risk is unclear, reasoned the vice chairman, the net impact of consolidation on systemic risk is also uncertain. Consolidation has encouraged the creation of a number of large and increasingly complex financial institutions. If such an institution should become seriously distressed, said Ferguson, consolidation and any attendant complexity might increase the difficulty of winding down the organization.

The risks to individual firms and to the financial system could be reduced by stepped-up efforts to understand the implications of working out a large and complex financial institution. Because no institution is too big to fail, the Fed official urges regulators to develop a clearer understanding of the following:

the administration of bankruptcy laws and conventions across borders;
the coordination of supervisory policies within and across borders;
the treatment of over-the-counter derivatives, foreign exchange and other market activities in distress situations;
the roles and responsibilities of managers and boards of directors; and
the administration of the lender-of-last-resort function.

Consolidation has increased demand by market participants for information regarding a firm’s financial condition. The resulting rise in disclosures has improved firm transparency and encouraged market discipline, observed the senior official, and has thus lowered individual firm risk and perhaps increased financial stability. However, the increased complexity of firms has also made them more opaque, he emphasized, and their increased size has the potential to augment moral hazard. There appears to be considerable room for improvement in disclosures by financial institutions, noted Ferguson.

PAYMENT AND SETTLEMENT SYSTEMS

Financial consolidation is also affecting the market structures for payment and securities settlement by leading to a greater concentration of payment and settlement flows among fewer parties. Fortunately, the greater concentration of payment flows does not appear to have decreased competition in markets for payment and settlement services. However, Ferguson believes that consolidation may lead to a significant shift of risk from interbank settlement systems, where risk management may be more robust and transparent, to customer banks and third-party service providers, where risk management practices may be harder for users to discern. Moreover, to the extent that consolidation results in a greater concentration of payment flows, the potential effects of an operational problem may increase.

These and other developments imply that central bank oversight of the risks in interbank payment systems is becoming more closely linked with traditional supervision of individual institution safety and soundness. As a result, the vice chairman foresees that increasing cooperation and communication between banking supervisors and payment system overseers may be necessary both domestically and internationally.