Description
The private financial industry plays a pivotal role in the functioning of many economies in the world. Banks, insurance companies and other less well-known financial service providers intermediate capital flows for governments, corporations and individuals, which affect people’s lives and the choices available in society.
Critical Issues in the
Financial Industry
SOMO Financial Sector Report
Myriam Vander Stichele
SO M O
This SOMO report critically analyses the functioning and regulation of banks,
insurance companies and other ?rms in the ?nancial industry. Although the ?nancial
industry is a crucial player in corporate globalisation, e.g. through its “investment
banking”, civil society scantly monitors the private ?nancial sector. This report
aims at explaining the terms used in the private ?nancial sector and increasing the
understanding of its functioning.
More speci?cally, the report focuses on trends, structures, strategies, regulations and
corporate social responsibility initiatives at the international level. The analysis clearly
identi?es “critical issues” that reveal the negative effects of the ?nancial
industry on society, developing countries, poverty eradication, and sustainable
development. This report intends to support the work of civil society organisations
and individuals who are involved in campaigns dealing with issues such as destructive
projects ?nanced by banks, corporate social responsibility, GATS, stopping unstable
and speculative capital ?ows, poverty eradication and sustainable development.
Critical Issues in the Financial
Industry
SOMO Financial Sector Report
Myriam Vander Stichele
April 2005 (updated)
Colophon
Critical Issues in the Financial Industry
SOMO Financial Sector Report
By:
Myriam Vander Stichele
Update in 2005 assisted by Jante Parlevliet
Published by:
Stichting Onderzoek Multinationale Ondernemingen
(SOMO)
Centre for Research on Multinational Corporations
Cover Design:
Annelies Vlasblom
Copyright © 2005
First published in March 2004
SOMO, Amsterdam
This report is financed by:
The Dutch Ministry of Foreign Affairs and NOVIB
Additional copies are available from:
SOMO
Keizersgracht 132
1015 CW Amsterdam
Phone: +31 (0)20 6391291
e-mail: [email protected]
Download and ordering at www.somo.nl
Contents
Contents................................................................................................................... 3
General introduction What the report is about .................................................... 6
Glossary ................................................................................................................... 9
Some figures to compare ..................................................................................... 11
Chapter 1 Financial services: what they are, some trends and critical
issues ..................................................................................................................... 13
Introduction .....................................................................................................................13
1.1 Banking................................................................................................................13
1.1.1 Retail banking and commercial banking...............................................................13
1.1.2 Lending of all types and related services .............................................................16
1.2 Services related to securities and asset management .........................................23
1.2.1 Investment banking..............................................................................................23
1.2.2. Private equity firms...............................................................................................28
1.2.3 Research, trading and brokerage.........................................................................29
1.2.4 Derivatives services .............................................................................................31
1.2.5 Hedging................................................................................................................33
1.2.6 Asset management ..............................................................................................36
1.2.7 Pension funds ......................................................................................................36
1.2.8 Mutual funds ........................................................................................................37
1.2.9 Trust services.......................................................................................................40
1.3 Rating services ....................................................................................................41
1.4 Insurance services ...............................................................................................42
1.5 Conclusions from the perspective of poverty eradication and sustainable
development ........................................................................................................46
Chapter 2 Insights in the financial industry: trends and strategies................ 51
Introduction .....................................................................................................................51
2.1 Performance of the financial services industry.....................................................51
2.2 Structure of the financial industry: rankings of top financial firms.........................54
2.2.1 World rankings.....................................................................................................54
2.2.2 A short analysis of the world top financial conglomerates....................................55
2.2.3 Regional rankings ................................................................................................59
2.2.4 Sectoral ranking...................................................................................................61
2.2.5 Global concentration in some financial services sectors......................................63
2.3 Trends and strategies: financial service companies.............................................64
2.3.1 Consolidation .......................................................................................................64
2.3.2 Competition..........................................................................................................69
2.3.3 Shareholder value................................................................................................72
2.4 Conclusions and critical issues ............................................................................73
Chapter 3 The case of Indonesia ......................................................................... 77
Introduction .....................................................................................................................77
3.1 Domination of the banking sector compared to other financial services .............. 77
3.2 The role of banks in servicing the poor ................................................................ 77
3.2.1 Weak support for small and medium sized enterprises ....................................... 77
3.2.2 The role of banks and the poor............................................................................ 78
3.2.3 Foreign banks give little or no credit to poor ........................................................ 79
3.2.4 Neglecting poor regions....................................................................................... 79
3.2.5 Increase in consumer credit rather than investment credit .................................. 80
3.3 Deregulation and the lack of regulatory and supervisory capacity....................... 82
3.4 The critical roles of lending by foreign banks....................................................... 82
3.4.1 The role of lending by foreign banks in the financial crisis................................... 82
3.4.2 Odious governmental and private debt ................................................................ 83
3.5 Private project and company financing carried over to governments .................. 85
3.6 Privatization......................................................................................................... 87
3.6.1 Privatization of the banking sector....................................................................... 87
3.6.2 Financing privatization by the financial industry................................................... 88
3.7 Critical issues related to labour in the private financial sector ............................. 89
3.7.1 Lay offs................................................................................................................ 89
3.7.2 Not respecting labour laws .................................................................................. 89
3.7.3 Discrimination between foreign and domestic employees at foreign banks......... 89
3.8 Conclusions: critical issues for developing countries........................................... 90
Chapter 4 Corporate Social Responsibility initiatives in the financial services
sector ......................................................................................................................92
Introduction..................................................................................................................... 92
4.1 CSR initiatives and guidelines covering all financial services.............................. 93
4.1.1 UNEP Finance Initiative....................................................................................... 94
4.1.2 The EPI-Finance 2000 initiative to develop environmental measurement
indicators ............................................................................................................. 96
4.1.3 WBCSD Working Group Finance ........................................................................ 97
4.1.4 UN ‘The Global Compact’ Financial Institutions’ Initiative.................................... 98
4.1.5 Wolfsberg principles............................................................................................. 98
4.1.6 The Collevecchio Declaration by NGOs .............................................................. 99
4.1.7 Further developments and critical issues........................................................... 101
4.2 CSR aspects in retail and corporate banking..................................................... 102
4.2.1 Project financing................................................................................................ 102
4.2.2 Equator Principles by banks .............................................................................. 102
4.2.3 Beyond the Equator Principles .......................................................................... 104
4.2.4 Integration of environmental and social aspects in regular corporate financing. 106
4.2.5 Retail banking.................................................................................................... 106
4.2.6 Alternatives ........................................................................................................ 107
4.3 Asset management and socially responsible investment................................... 107
4.3.1 Investing in companies - socially responsible investment (SRI) ........................ 108
4.3.2 Mutual funds and ethical funds: is there a difference?....................................... 109
4.3.3 UN norms for responsible investments for institutional investors....................... 110
4.3.4 Pension fund management ................................................................................ 110
4.4 Insurance and Corporate Social Responsibility ................................................. 111
4.4.1 Responsibility on social aspects not yet developed........................................... 111
4.4.2 Environmental issues in CSR initiatives............................................................. 113
4.4.3 UNEP Finance Initiative on insurance focuses on environment.........................114
4.4.4 Example of individual or branch CSR Initiatives................................................114
4.5 Investment banking............................................................................................115
4.5.1 CSR issues from the Global Reporting Initiative ................................................115
4.5.2 Issuing bonds from the World Bank ...................................................................116
4.5.3 Emissions trading...............................................................................................116
4.6 Reporting initiatives by financial institutions.......................................................116
4.6.1 Social performance reporting through the GRI Financial Services Sector
Supplement........................................................................................................117
4.6.2 Environmental reporting indicators.....................................................................119
4.6.3 Reporting on sustainable credit activities by banks............................................120
4.7 Conclusions and critical issues ..........................................................................122
Chapter 5 Governmental regulations at the international level.................... 128
Introduction ...................................................................................................................128
5.1 Trends of regulation and supervision at national levels .....................................128
5.2 Regional financial services markets and regulation ...........................................131
5.3 International regulation and supervision of corporate financial services ............132
5.3.1 Bank for International Settlements (BIS) ............................................................134
5.3.2 International Association of Insurance Supervisors (IAIS) .................................141
5.3.3 International Organisation of Securities Commissions (IOSCO) ........................142
5.3.4 Supervising and regulating all-finanz firms.........................................................144
5.4 Regulation, supervision and decisions related to capital flows and the
international financial system.............................................................................146
5.4.1 International fora for discussing financial system stability..................................147
5.4.2 State of the reform of the international financial system.....................................152
5.5 Relation of financial services with auditors.........................................................156
5.6 Conclusions and critical issues ..........................................................................158
5.7 Sustainability and Accountability in the Financial Services Sector Regulatory
and public policy recommendations ...................................................................161
Chapter 6 Trade in financial services: liberalisation in the GATS Agreement
and insufficient assessment of the risks.......................................................... 168
6.1 The GATS instruments to liberalise financial services .......................................168
6.1.1 The rules of the GATS Agreement .....................................................................168
6.1.2 The Annex on Financial Services.......................................................................171
6.1.3 The GATS agreement includes a model for swift liberalisation..........................171
6.1.4 After the Uruguay Round: the Fifth Protocol to the GATS..................................173
6.2 Assessing the risks for developing countries .....................................................173
6.2.1 Liberalisation of financial services under GATS.................................................173
6.2.2 The risks of financial instability in developing countries .....................................182
6.2.3 Who will decide on what prudential regulation and capital account policies?.....189
6.2.4 Little link between the GATS negotiations and national financial authorities......192
6.2.5 Too little coordination between GATS negotiations and international stability
fora.....................................................................................................................194
6.3 Summary with conclusions and critical issues ...................................................196
Annexes................................................................................................................ 204
Critical Issues in the Financial Industry
General introduction – What the report is about 6
General introduction
What the report is about
The private financial industry plays a pivotal role in the functioning of many economies in
the world. Banks, insurance companies and other less well-known financial service
providers intermediate capital flows for governments, corporations and individuals, which
affect people’s lives and the choices available in society.
By raising, allocating and pricing capital and providing risk coverage, they have a major
influence on:
who in society gets access to financing and protection against risks;
what activities by governments, corporations or individuals get financed or
protected against risks;
how financial services benefit the rich or the marginalized, sustainable
development or environmental destruction.
The private financial sector has several types of financial services that affect societies as
well as the international economy. Regulating and supervising financial firms and their
diverse services is difficult due to the complexity of financial ‘products’ and risk
management, and due to the speed at which financial firms facilitate huge amounts of
capital to flow around the world. Moreover, the private financial industry has successfully
argued for national and international free markets and legal frameworks that prevent too
much intervention by national and international authorities.
After crises like the Asian financial crisis in 1997-98, there was a lot of talk about reform of
‘the’ financial architecture. It is often overlooked that the dominant players in international
financial system are private financial services providers, including the ‘institutional
investors’. Because there is much less public knowledge about financial firms than about
governmental financing institutions like the World Bank, this financial sector report focuses
on private financial firms including banks, insurance companies, investment banks and
pension funds. The report intends to provide basic information about:
the mechanisms and the operation of private financial services (chapter 1),
the structure and the major players in the financial services market, and trends
and strategies in the financial industry (chapter 2),
important issues and concerns for developing countries, based on a case study of
Indonesia (chapter 3),
initiatives taken around corporate social and environmental responsibility (chapter
4),
how the private financial industry is regulated and supervised at the international
level (chapter 5),
Critical Issues in the Financial Industry
General introduction – What the report is about 7
how trade in financial services and investment by financial firms is regulated by
the WTO agreement on services (GATS) and what the risks are for developing
countries (chapter 6).
This report focuses on trends, structures, regulations and corporate responsibility
initiatives at the international level. The scope of the report did not allow for analysis of
each country. Only an Indonesian case study by Business Watch Indonesia on the
financial services industry is included to provide a useful developing country insight.
Each chapter strives to indicate the problem areas in every financial sub-sector. The focus
is on those aspects that negatively affect society, developing countries, poverty
eradication, and sustainable development. These are indicated as "critical issues". The
conclusions of each chapter review the main critical issues and topics.
In this way, the report would like to inform and analyze problems surrounding the private
financial industry for organizations, individuals and institutions which:
are involved with corporations, big projects and privatization, and their financiers,
which destroy the environment and violate human rights;
are campaigning about trade agreements, such as the GATS agreement, in which
opening of the financial services market is on top of the agenda without any
democratic scrutiny;
want to free the world of unstable international capital flows and complex financial
services that undermine entire economies and people’s lives;
want to solve debt problems of developing countries, which reduce government
budgets intended for eradicating poverty, social improvements and promoting
environmentally friendly development;
want to avoid the widening gap between rich and poor in all countries and work
on alternatives to the current globalised free market economy;
understand what goes on behind corporate scandals such as Enron and
Parmalat.
The report is published by the Centre for Research on Multinational Corporations
(SOMO), a non-profit research institute that advises non-governmental organizations and
trade unions in the Netherlands and worldwide.
Research for this report was based on information from literature, data bases, NGO
analysis and input at workshops in Cancun (12 September 2003), The Hague (19
November 2003) and Amsterdam (13 January 2005), and last but not least the sector,
country and corporate reports commissioned to Business Watch Indonesia. The expertise
of SOMO researchers and writing by Myriam Vander Stichele lead to the analyses and
results of this report. Thanks go to Martin Koehler (Campagna per la reforma della Banca
Mondiale), Peter Wahl (WEED), Johan Frijns (Bank Track), and others who commented
and supported the writing of the report. In beginning 2005, the report was updated with the
assistance of Jante Parlevliet to incorporate most important new events.
Critical Issues in the Financial Industry
General introduction – What the report is about 8
SOMO's research of the financial sector is part of a four-year program of research of
sectors of importance to civil society, poverty eradication and sustainable development,
financed by the Ministry of Foreign affairs in the Netherlands. Financial support for
researching the financial sector also came from NOVIB (NL).
Myriam Vander Stichele
Amsterdam, April 2005
Critical Issues in the Financial Industry
Glossary 9
Glossary
This report explains many words used in the financial services industry, mostly in chapter
one. A word that is explained for the first time in the report is underlined. Below are some
general terms used throughout the report.
Assets
Anything that has commercial or exchange value and is owned by a business, institution
or individual, for instance shares or real estate.
Bailing out
Financial support by governments to banks or other financial firms that are in financial
distress and could go bankrupt, possibly disrupting the whole economy.
Bond
An interest-bearing security issued by governments, banks or companies, which obligates
the issuer to pay the bondholder a specified sum of money, usually at specific intervals,
and to repay the principal amount
Credit risk: the chance that the debtor will not repay the loan or other form of debt (e.g. a
bond).
Collateral: something of value that is given as a guarantee for repayment of a loan or
other form of debt. Often it concerns real estate but many other assets can be used,
including land, part of a business, or financial assets. In case the borrower fails to repay
the loan on the agreed terms, the bank will have the legal right to seize the collateral.
Debt finance: with this form of finance, the financiers lend money to a company,
government or project. This can be in the form of a bond or a loan. The returns of the loan
and bonds are normally fixed.
Deposit: a sum of money lodged at a bank or other depository institution. The money can
be withdrawn immediately or at a agreed time (‘time deposits’). Sometimes deposit earn
interests, especially if it concerns a time deposit.
Derivative
A contract which specifies the right or obligation between two parties to receive or deliver
future cash flows, securities or assets, based on a future event.
Equity finance: in this form of finance, financiers buy a share in the company or project
and are thus a partial owner. Their returns depend on the success of the firm/project.
Equities
Ordinary shares, i.e. ownership interests possessed by shareholders in a corporation, as
opposed to bonds.
FT
In references means: the Financial Times
FTFM
In references means: Financial Times Fund Management (weekly review of the
investment industry)
Critical Issues in the Financial Industry
Glossary 10
Institutional investors
Investors with large amounts of funds under their management, such as pension funds,
insurance companies, mutual funds and bank trust departments.
Principal
Amount of a loan, separate from interest to be paid.
Securities
Bonds, shares or stock, and derivatives.
Securitization
Process of bringing together in a pool debt instruments (e.g. loans) which generate
predictable cash flows, then selling to investors new securities backed by the pool.
Stock
Is the equivalent of the UK term share(s).
Share
Units of ownership in a company, issued by a company as a means of raising long term
capital; shareholders receive some part of the company's earnings through dividends;
"voting shares" carry the right to vote at company meetings.
Reserve requirements: requirements on the amount of funds a bank has to hold in reserve
against deposits made by their customers. This money has to be held in the vaults of the
bank, or the respective central bank.
Underwriting
Introducing new shares on the stock market and assuming the risk of buying the new
issue of shares or bonds from the issuing corporation or government entity and reselling
them to the public; the underwriter guarantees to buy any shares of a share issue which
are not bought by the public, which creates public confidence.
Syndicated loan: loans for large, possibly risky commercial or government projects
provided by a group of banks and other financial institutions, called a bank consortium or a
syndicate.
Option: a contract between two parties that offers the buyer of the option the right to buy
(or to sell) an asset (e.g. a financial security) from (to) the contracting party at a agreed
upon price, within a certain period of time.
Future: a contract between two parties in which the buyer of the future party is obliged to
buy (or to sell) an asset (e.g. a financial security) from (to) the contracting party, at a
agreed upon price, within a certain period of time.
Critical Issues in the Financial Industry
Some figures to compare 11
Some figures to compare
Gross Domestic Production (GDP) in 2003
1
Gross domestic product of the economically richest country, the US $ 10, 949 bn
($ 11,0 trillion)
GDP of the reported poorest country, Kiribati $ 0.055 bn
($ 55 million)
Total GDP reported in the world $ 36,460 bn
($ 36.5 trillion)
Gross National Income (GNI) per capita 2003
2
GNI per person in the richest country reported, Luxembourg $ 45,740
GNI per person in the poorest country reported, Ethiopia $ 90
World GNI per capita $ 5,510
FDI
Total world foreign direct investment (FDI) in 2002 $ 651 bn
Total FDI to developed countries in 2002 $ 460 bn
Total FDI to developing countries in 2002 $ 162 bn
AID
Total official overseas development aid (ODA) in 2002 $ 58 bn
Additional annual aid needed to achieve Millennium Development
Goals $ 40-60 bn
Debt
5
Total debt of all developing countries in 2003 $ 2,554 bn
($ 2.6 trillion)
Total debt by all developing countries to private creditors $ 595,1 bn
Developing countries’ use of IMF credit in 2003 $ 106,9 bn
Trade
6
Total world exports of merchandise in 2003 $ 7,579 bn
($ 7.6 trillion)
Total world exports of commercial services in 2003 $ 1,729 bn
($ 1.7 trillion)
Financial markets in 2003
7
Total value of equities (world stock market capitalization) in 2003 $ 31,202 bn
($ 31 trillion)
Total world value of public and private debt securities in 2003 $ 51,305 bn
($51 trillion)
Total value of assets managed by commercial banks (bank assets)
in 2003 $ 47,834 bn
($ 48 trillion)
Critical Issues in the Financial Industry
Some figures to compare 12
Value of US mutual fund industry in January 2004
8
$ 7,537 bn
($ 7,5 trillion)
Value of US hedge fund industry in January 2004
9
$ 795 bn
Notional value of global amounts outstanding of
over-the-counter (OTC) derivatives by June 2003
10
$ 169,678 bn
($169.7trillion)
Total recorded claims on offshore centres in the second quarter
of 2003
11
$ 1,800 bn
($ 1.8 trillion)
Profits of financial firms
Total net profit
12
of the 41 financial firms that belonged to the 100
biggest global companies in 2002-2003 $ 166.9 bn
Total net profit of Citigroup, the world's top financial firm, in 2004
13
$ 17.0 bn
Commissions paid by migrant workers for transferring earnings home,
according to US Treasury registration in 2001
14
more than $1bn.
Pensions
Total pension fund assets of the world's top 5 pension markets
in 2003
15
$13,077 bn
Pension funds are world wide under funded by 20% $1,500 bn to $2,000bn
1
World Bank, Quick Reference Tables, Total GDP 2003, at www.worldbank.org
2
GNI differs from Gross National Product (GNP) in that it includes a terms of trade adjustment. See:
World Bank, Quick Reference Tables, GNI per capita 2003, at www.worldbank.org
3
UNCTAD, Development and Globalization. Fact and Figures. 2004, p33, at www.unctad.org
4
OECD, OECD Report Shows Rising Aid Flows but More Effort Needed to Reach Monterrey Goals, 28
January 2004.
5
World Bank, World Development Indicators 2005, table 4.16, at www.worldbank.org. Developing
countries here refers to World Bank’s low and middle income countries
6
World Bank, World Development Indicators 2005, tables 4.5 and 4.7, at www.worldbank.org
7
IMF, Global financial stability report, April 2005, p. 163
8
Grace Toto, Monthly statistical review, SIA Research Reports, 20 September 2004, p 27, at
www.sia.com
9
Kyle L. Brandon, The State of Hedge funds: 2004, SIA Research Reports, 20 September 2004, p 6, at
www.sia.com
10
BIS, Quarterly review, March 2004, p. A99
11
BIS, The international banking market, in Quarterly review, December 2003, p. 16
12
Forbes 2000 list, March 2004, at: www.forbes.com : based on a composite of sales, profits, assets and
market value; including figures of net profits in 2003 and 2002.
13
Citigroup, Annual Report 2004, available at www.citigroup.com
14
J. Authers, Mexicans send more than $ 1 bn back home in July, in FT, 19 September 2003.
15
Watson Wyatt, in S. Targett, Pension gloom is lifting, in FTfm, 19 January 2004, p. 2
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 13
Chapter 1
Financial services: what they are,
some trends and critical issues
Introduction
The private financial industry, or “financial services sector”, makes money by raising and
allocating capital, and by providing protection against many kinds of risk.
The various financial services and the ways in which they work will be explained
1
in this
chapter. The latest trends, problems and some critical issues relating to sustainable
development and poverty eradication will also be outlined for each branch of financial
service.
Some financial services may seem obvious, whilst others are much more complex and
less transparent to the general public or civil society organizations.
Chapter 2 will give more insight into which firms provide the various financial services, and
the structure and the trends in the financial services market. Issues related to developing
countries, corporate responsibility, regulations and liberalisation of these financial services
are also explained in separate chapters.
The overview below is organized categorically with the services the financial industry
offers. These financial services categories are also used in the free trade agreements,
including the agreement on services in the GATS agreement of the WTO (see chapter 6).
1.1 Banking
1.1.1 Retail banking and commercial banking
Retail and commercial banking refers to banking services open to the households and
small companies. In contrast, corporate banking focuses on large, corporate and
institutional clients (‘wholesale clients’) only.
Commercial banking
There are different kinds of retail banks. The biggest group are the commercial banks,
which service both households and small and medium enterprises (SME’s) and wholesale
clients. Typical services of commercial banks to households and SME’s are acceptance
and repayment of deposits from which banks make commercial, consumer and mortgage
loans. In addition, they provide different kind of payment services like bank cards, credit
cards and e-banking. The services offered to big corporate clients are similaralthough the
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 14
type of services provided by corporate banking divisions of financial institutions are much
more extensive.
Other types of retail banks
In the retail sector, in addition to commercial banks there are also some other financial
institutions where you can keep a deposit (sometimes also referred to as ‘thrift
institutions’). In the US especially, Savings and Loan’s (S&L) banks are an important
banking institution. They obtain funds through deposits, and use these mainly to provide
long-term mortgage loans. Mutual savings banks operate similarly. However, their
organizational structure is quite different, since the depositors own the bank. Finally, credit
unions are small cooperative deposit institutions that are often organized around a union
or a firm. They obtain funds by issuing deposits and use these to make particularly
consumer loans.
Trends and critical issues
Market Segmentation
Studies show that 20% of the customers at retail and commercial banks generate
as much as 200 percent of the profits whilst the remaining customers actually
undercut profits.
2
In response, many banks in western countries in the 1990’s
decided to divide up their services around the customer, rather than around
products or channels, according to the profits made from various client types.
3
Clients, regardless of whether they are received in person, through the internet or
call centres, are then dealt with according to a pre-set level of services, fees, and
privileges.
4
Services to the ‘poor’ have been drastically cut whilst services to small
and medium-sized enterprises (SMEs) are much less than to those for the larger
corporations.
Closing branches and opening redesigned branches
Market segmentation has also resulted in closing and streamlining branches in
most western countries. Those remaining branches focus on selling financial
products, which earn more profit (i.e. loans) from richer clients. Call centres and
automatic tellers, which replace branch staff, often leave the client wondering if
"there’s anybody out there?". In the Netherlands, the amount of bank branches
was reduced by 40% in 5 years, i.e. from 7 000 in 1998 to 4109 in 2003.
5
Many banks have been losing clients due to the downgrading of retail services but
in the last year or so in some cases, client contact has been re-valued and steps
have been taken to improve human-to-human contact. Clients of Barclays and
HSBC in the UK and others should watch out for the new branch trend, which is
all about "eye contact" and offering a "library" setting, where you can sip coffee
and read promotional brochures. Even though the redesign is aimed at increasing
customer satisfaction, cutting costs to increase revenues means you will still have
to do many transactions yourself.
6
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 15
Reducing direct services for the poorer
In line with market segmentation and cost cutting or profit opportunities, banks are
pushing or obliging customers to use cheaper automated services or automated
channels such as the internet or automatic money distributors (ATMs) for
transactions on one’s personal account. For example, in the Netherlands cash
dispensers on the street must be used to withdraw Euro 500 or less, which is a
problem for many including the elderly.
Many European banks in 2001 intended to switch the 80% of the least profitable
clients to automatic channels for low added-value transactions, and at the same
time sell to these clients different products through the internet.
7
One tactic to
persuade people to use the automated services is to offer better interest rates on
deposits made on the internet, even though e-finance is not yet fully secure.
Sometimes banks exclude the very poor
8
from services by, for example,
identifying city areas, or “red-lining” areas, on the map considered poor, where
banks refuse to provide certain financial services. And within these areas low-
income households do not have access to mortgage loans.
9
In developing countries, the very poor often have no access to saving accounts or
they have to pay for them. Those already excluded from society, the marginalized
and poor, are often excluded even further due to their lack of access to basic
financial services and most countries don’t have laws obliging banks to provide
access to basic services.
Cross selling
Banks distribute other financial products to clients through existing branches,
including insurance products and policies, and mutual funds.
Customer’s choice?
Theoretically consumers can freely choose and change their retail banks but in
some cases it is not possible to retain account numbers when changing banks,
which makes changing banks less interesting. New laws in some Western
countries allow customers to keep their account number if they switch, which is
intended to increase competition and improve customer customer service.
10
Run on the banks
When clients loose trust in their bank, fearing that it will go bankrupt, they run on
the bank, to get their money out. Since banks do not actually have all their clients’
savings in the vaults available for full withdrawal at any one time, clients' ‘running
on the bank’ could result in the bank collapsing or exacerbating an wider, existing
banking crisis.
The risk of a run on the banks is still a problem in developing countries as was the
case in Argentina during the financial crisis from 2001 onwards and in Zimbabwe
in January 2004.
11
In some countries, foreign banks are often trusted more, but it
is the richer people who can afford their more expensive services. Not all
countries require banks to have a deposit insurance system, which guarantees
the repayment of at least some of the clients' savings.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 16
Transfer of migrant remittances
The cash sent home by migrant workers, in many developing countries, exceeds
the capital inflow from foreign direct investment. Traditionally these transfers were
sent by money order, which had high commission fees. In 2001, the US Treasury
registered more than $1bn commissions made by migrant workers.
The surge in electronic transfers has allowed more financial firms to enter into this
oligopolistic financial service sector, thus increasing competition, which has lead
to a drop in commission fees. At the same time, migrant workers can more easily
send smaller sums of money back home.
12
1.1.2 Lending of all types and related services
For many banks, offering loans is a significant business and is one of the ways the bank
actually creates money. Loans can take many forms (credit cards included) and can go to
individuals, companies, other banks (or inter-bank lending), large projects, governments or
governmental organizations.
Mortgage banking
When a bank sells a loan for real estate, sometimes combined with insurance and mutual
funds, they are selling a mortgage. The bank’s revenue comes from the commission fees
and servicing the debt (loan servicing) by way of interest payments, and sometimes from
the resale of the loan to other investors.
Project lending
Project loans refer to loans for big projects by governments or corporations for the
construction of infrastructure including oil pipelines, powerhouses and dams. These loans
often contain loan covenants or agreements between the lender and the borrower about
what the borrower should or should not do, such as regular reporting, adequate insurance
and asset reserves.
Trends
Syndicated loans
Syndicated loans are loans for large risky commercial projects or for governments
and are financed through a group of banks and other financial institutions called a
bank consortium or a syndicate. The bank coordinating the consortium and the
syndicated loan could be different from the banks’ providing the loans in the
consortium.
Credit risk mitigation
Banks have mechanisms, through credit derivatives and credit securitization (see
below), which they use to spread out the actual risks of the loans and credit. Risk
mitigation instruments are used by banks which concentrate credit in certain
sectors of their expertise and are vulnerable to heavy losses should the particular
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 17
sector take an economic downturn. Risk mitigation instruments are considered by
some as being one of the reasons Brazil was affected by the Asian financial crisis
in 1997-98.
Credit risk mitigation instruments are contracts that are mostly traded13 between
bankers and investors. The credit derivative market was estimated at $ 40 bn
(outstanding notional value) in 1996 and $ 1.2 trillion at the end of 2001. The
massive growth is expected to continue and to reach an outstanding notional
value of $ 4.8 trillion by the end of 2004.
14
Credit derivatives
Relatively new to the commercial banking sector, but on the rise over the past 5
years, a credit derivative
15
is a contract between two parties that allows for the
use of a derivative to transfer credit risk from one party to another. The derivative
is based on a credit, either a loan or bond in most situations.
The derivative contract stipulates the fees the two parties pay each other,
depending on the kind of derivative and the risks (e.g. non repayment of the loan)
covered. The protection buyer, most often the bank, remains the owner of the
original loan.
The most common credit derivatives are credit default swaps
16
which are
agreements where credit risk and fees of a third party are transferred from one
party to the other. The first party in the swap is a lender and faces credit risk from
a third party. The counter-party (or the protection seller) in the credit default swap
agrees to insure the default risk in exchange of being paid regular periodic
payments (i.e. essentially an insurance premium).
If the third party defaults, the second party assuming the risk will have to
purchase from the first party the defaulted asset. In turn the protection seller pays
the protection buyer the remaining interest on the debt as well as the principal.
Other forms of credit derivatives are total-return swaps, and credit-spread put
option contracts. The number of types of credit derivatives that are traded among
protection buyers and risk sellers is ever increasing.
Securitization
Securitization involves the packaging of debt (like loans or mortgages), which
generates predictable cash flows, in a pool and selling these to investors in the
form of securities. Securitization is a relatively new but fast growing form of debt
financing. Over a period of 20 years, securitization became one of the largest
sources of debt financing (or credit provision instrument) in the US and is also on
the rise in Europe and Asia.
The securitization of (bad) loans and other debt instruments means the credit
risks is removed from the bank or loan provider and is spread among the buyers
of the securities. As a consequence, it becomes unclear exactly who assumes the
risks. However, the point is that the bank that provides the loan, does not have to
deal with bad debts
17
.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 18
Project finance
Project finance refers to finance especially directed to big, mostly infrastructure projects like oil
pipelines, hydroelectric dams and telecommunication infrastructure. After massive privatization
and deregulation of industrial sectors, since the early 1990’s, private sector financing of these
projects has grown enormously.
It is a form of credit that responds to the particular characteristics of large projects. The initial
costs of the big projects are very high, while the benefits can only be reaped in the longer term.
All kinds of risks are involved (financial, environmental, political etc.), and therefore project
finance has evolved to be a very complex issue. Finance for big projects can take two forms:
equity and debt. If the risks of the projects are high, a substantial percentage of the finance is
provided through equity arrangements, that is, those financiers “own” the project, and thus also
will bear the costs in case of a failure of the project. Other financiers often require a high level
of equity finance, because the existence of a substantial group of shareholders will increase the
real commitment to the success of the project.
If the risks are perceived smaller, there is normally more debt finance. Debt finance again, can
take two forms: loans and bonds. Project loans are made by commercial banks and normally
contain loan covenants or agreements between the lender and the borrower about what the
borrower should or should not do, such as regular reporting, adequate insurance and asset
reserves.
Increasingly, projects are also financed through project bonds. Banks then assist the company
or government in attracting private funds, by underwriting project bonds. (for underwriting, see
section 1.2) Like with project loans, in the issue of project bonds the terms of the agreement
are included in a bond covenant.
Although governments have left the financing increasingly to the private sector, they remain
involved in the design and the conditions of the projects. Local governments can be involved as
a contracting party that will buy the infrastructure after the project has been finished. Host
governments of the construction companies can be involved when their Export Credit Agencies
(ECA’s, see section 1.4) offer insurance for the payment of their activities. Also, taking into
account the enormous risks involved in some projects, participants often require the
involvement of multilateral development banks like the European Bank for Reconstruction and
Development or the International Finance Corporation (the World Bank’s private arm) to back
the project. As a result, project finance often takes the form of hybrid public-private
partnerships.
Social movements are increasingly concerned with the impact that financial lending, to
companies and for projects, has on the environment and human rights. Current project lending
often results in unsustainable practices because financiers do not produce reasonable
environmental and social impact assessments of the projects they are financing. The lack of
sustainability criteria and regulation combined with the lack of transparency for those individual
‘savers’ (who are interested in knowing how the bank is using their savings) and channels for
those savers to voice their concerns also leads to unsustainable practices. This issue is further
discussed below (Chapter 4).
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 19
Critical issues in lending services
Credit to small and medium entreprises (SME’s) lacking and too expensive
Most financial firms see lending to SMEs as a high risk and administratively
costly, which mean SMEs have less access to credit and the interest rates they
pay are higher than what larger corporations are offered. Yet, SMEs are often the
most dynamic and innovative segment of many countries and provide the bulk of
employment. This problem is sometimes recognized at the national or
international levels but it has not been successfully resolved.
To promote economic growth and reduce escalating poverty, delegates at the
Summit of the Americas in January 2004, called for the promotion of small credits
to individuals and small producers.
18
Ironically, the Summit also called for more
free trade. It is exactly the fierce competition within the financial service sector, as
a result of free trade, that has lead to SMEs being denied credit due to their high
costs and perceived risks. For example, in Mexico, the entry of foreign banks has
not lead to the improvement of the banking sector as many had hoped. Foreign
banks, especially Spanish and US ones, now control 80% of the banking sector.
Although rich clients in generally are being served well, households and SME’s
have a hard time getting loans from these banks. This situation has led the
Mexican central bank and politicians to publicly raise concerns, since foreign
banks are often also harder to regulate than domestic ones. Under the current
climate, it is unlikely that more credit will become available to SMEs without
government intervention and support. The World Bank has started trainings, with
Citigroup, to promote the financing of SMEs in Latin America
Minorities have less access
Research has revealed that African-Caribbean businesses have extra difficulties
in the UK accessing finance due to discrimination and a lack of trust.
19
Some
banks around the world promote ethnic banking to attract the minority and
immigrant clients, however gaps remain between bank policies and
implementation.
Predatory lending
In some countries, banks and other financial firms aggressively sell easy loans
with high interest rates designed specifically to exploit vulnerable and
unsophisticated borrowers. People in metropolitan areas in the US -including
minorities, low and middle income borrowers, women and others excluded from
mainstream credit- are particularly targeted and victimized by predatory lending
and high interest rates, which further marginalizes these groups in society.
20
Existing laws do not protect these vulnerable members of society but rather
sanction predatory lenders.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 20
Credit cards
Credit cards provide easy access to advanced payment and credit at home and
abroad. They make payments easier for the business sector and those who travel
because they avoid having to carry large amounts of money or foreign currency.
However, they have also severely increased indebtedness. The interest rates,
which are paid when payment is not immediate upon receiving the bill, are higher
than for credit from banks.
The level of personal indebtedness due to credit cards has reached crisis levels in
various countries including the US and UK because credit card holders purchase
items they can’t afford otherwise. In South Korea where credit cards have been
made readily available and consumption has been encouraged by governmental
incentives, many clients were unable to repay their debts when the economy
slowed down (US$ 5.8bn of unpaid bills in September 2003).
21
The government
has had to intervene at the end of 2003 in order to prevent credit card providers
from collapsing, thus affecting the whole South Korean banking system.
22
At the same time, credit cards are marketed in increasingly attractive ways. They
target specific groups like the young, who they hope will fall into debt at an early
age, thus remain lifelong credit card customers. Visa designed a mini-credit card
for young Asian consumers that attaches to a necklace or a bracelet.
23
In order to
attract customers, affinity credit cards are offered and allow customers support
charitable causes through their payments.
Non-banking financial services
Increasingly companies that do not offer financial services in their core business
(i.e. supermarkets) have started selling credit products as well as credit card
services. For example, in Canada the big chain supermarkets now have ‘banks’
on site, which can arrange a loan, a mortgage and take care of your savings.
They are getting into the financial service industry because they want to keep
their shopping customers and create a ‘one stop shopping/banking’ experience.
Debt market
When developing countries have problems paying back their loans, sometimes
the debt is written off from the lending banks' books (through bad loan provisions),
and/or sold by the lender, at a reduced price, to another financial service provider,
who then tries to recover the whole loan. This means that developing countries
are pressed to repay their loans while the lenders have already written off or
reduced the value of the loan.
Banks and other international financial firms that lend to developing countries
come together in informal networks like the "London Club" when repayment
problems occur. They collectively look with the defaulting developing countries at
repayment strategies, but generally this benefits the banks the most.
Credit risk mitigation products create new risks
Credit risk mitigation products, like credit derivatives, transfer the credit risk away
from banks to third parties. Perhaps this is why banks survived the rough
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 21
financial patch from 2001-2002 where loan defaults increased because the
economy slowed down and the stock markets dropped, and where the financial
capacity of many individuals and corporations was weakened.
However, regulators and experts worry that these credit mitigation mechanisms
could destabilize the banking system because:
The access to credit risk mitigation instruments might encourage the
credit providers to take more risks, or to be less prudent in assessing and
monitoring borrowers after the credit contract is signed.
24
Too many bad
loans might increase banks' risks and lead to destabilizing the banking
system
25
, the opposite of what risk mitigation instruments attempt to do.
Currently supervisors are afraid of unchecked, concentrated
accumulation of credit risk.
26
It is not fully clear to regulators where all the
risks are being transferred to, and the possible consequences. Especially
insurance companies are active buyers of credit derivatives, and thus
indirectly sell banks protection against credit loss. Mutual and pension
funds have also heavily invested in these instruments
27
. Defaults on
loans will now thus potentially endanger the financial position of these
investors (and the households whose money they manage).
The pricing of credit derivative contracts are complex to calculate and
document, and all the potentially important factors might not be included
in the model that calculates the risk,
28
upon which the derivatives are
based, resulting in some unexpected and heavy losses for the buyer.
More borrowing through low interest rates
Banks providing consumer credit and loans for housing or business profited in
2003 when the interest rates in many (western) countries were at a record low.
Low interest rates means credit is cheap and therefore more people tend to take
out loans. Banks profit from high lending despite the relatively small profit margins
from the difference between interest rates banks provide for savings accounts
and the interest rates they earn from lending. The problem is that when interest
rates increase, the rates for existing loans will also increase and the cost for
servicing the debt increases. If lending has been arranged without a careful
assessment of an individual or company’s payment capacity in a worse case
scenario, the banks might be left with bad loans.
29
This could undermine the
bank’s profitability, which undermines services for clients, the bank as a whole
and potentially the whole economy.
Micro-credit financing
Because large national and foreign banks are not interested in providing small
amounts of credit, micro-credit schemes have begun to flourish in poor and low
income areas.
The spreading of the micro-credit institutions, like the Grameen Bank, indicates
that there is a great demand for small amounts of credit and their payback
success rate indicates that low-income people can be a good credit risk.
Alternative banks and investment schemes try to provide the capital micro-credit
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 22
institutions require. The World Bank and even mainstream banks have
bourgeoning interest in micro credit.
For example, ABN Amro opened a micro-credit division in Brazil. It has however
been faced with the problem of selling the micro-credit product (loans) to weary
and suspicious entrepreneurs in the informal economy. ABN Amro wants the
micro-credit project to be profitable within 2 years.
30
There are many dilemmas
when large donors and mainstream bankers and investors get involved. The
benefits and the disadvantages have to be carefully weighed in order to judge
whether this mainstreaming is the best way to support poverty eradication.
Lending practices that undermine the economy: “Tanzi finance”
Financing of companies is changing from a system whereby repayment of loans and interests
is done through cash flows, to a more speculative financing system whereby only interest can
be paid through cash flows. In adverse circumstances, the companies have to sell some of
their assets to repay loans. There are more and more cases whereby the companies are
unable to meet their interest and principal repayment obligations from their cash flows (“Ponzi
finance”, after an Italian swindler called Charles Ponzi). They need to constantly raise new
funds, often through hidden or innovative systems, which can cause the company to collapse
under its debt burden (“Tanzi finance” after the owner of Parmalat, the collapsed dairy
multinational).
This more speculative financing is made possible through banks and other financial firms that
seek to make profits from more and more financing mechanisms, and increase their leverage
on the economy from the constant need for more finance.
An economy dominated by such speculative ‘ponzi financing’ supported by financial firms
becomes fragile and susceptible to a financial crisis. Such an economy is dependent on
continuing asset price inflation and larger amounts of credits. Small raises in interest rates or
declining company incomes might cause problems and compel companies to sell their assets.
When too many companies are in such financial trouble, the economy collapses as in the
1930s. Authorities can intervene, as the US has been doing for instance when the stock market
crashed (1987) or imploded (2001-2002), and during the saving and loans crisis (late 1980s).
But such intervention is encouraging more ‘Ponzi finance’ to a point where too much debt is
beyond salvation.
In the case of the collapse of Parmalat, special schemes –often designed by financial firms-
were used to hide the debt from investors, such as: ”bank loans rendered safe with credit
default insurance, asset-backed securities collateralised with fake invoices, credit-linked notes
which allowed the issuer to bet on its own creditworthiness, bonds which by secret covenant
varied the coupons payable according to the company's interest cover, liabilities sliced up and
distributed in collateralised debt obligations, and a myriad of finance company subsidiaries
registered in off-shore tax havens”.
Source: M. Vander Stichele, based on E. Chancellor, The perils of Tanzi finance, 22 February 2004,
at www.prudentbear.com
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 23
1.2 Services related to securities and asset management
Financial firms profit, i.e. make money, through financial products dealing with securities
including the issuing, trading and managing of securities. In addition, financial firms trade
and manage various other assets such as savings, foreign currencies, real estate,
commodities and gold.
1.2.1 Investment banking
Unlike traditional banks, investment banks do not accept deposits from, nor provide loans
to, individuals.
a. An investment bank is an institution that acts as an underwriter or agent for
companies or governments issuing securities (bonds and shares). The services of an
investment bank support the introduction of new shares to the (stock) market.
By underwriting, the investment bank buys all the new securities from the
issuer (a company, a government) at an agreed upon fee, thus the issuer
is guaranteed a certain minimum amount raised from the issue, while the
underwriter bears the risk. The underwriter then resells the new shares
directly to the market or to another investor. The underwriter guarantees
to buy any shares which are not bought by the public (which creates
public confidence). The profit for the underwriter is in the difference
between the price paid to the issuer and the public offering, which is
called the underwriting spread.
The investment bankers' role begins with pre-underwriting counseling
and goes on with pricing of the securities, stabilising the price of the issue
during the offering, and often continues after the distribution of securities
is completed, in the form of ongoing expert advice and guidance, often
including a seat on the board of directors of the company, and stabilising
the price of the security during the distribution period. Investment bankers
can also form an underwriting group, which pools and therefore
distributes the risk.
In other arrangements, investment bankers market a new issue without
underwriting it, acting as agent, and taking a commission for whatever
amount of securities the banker succeeds in marketing.
b. Investment banks play a large role in facilitating mergers, acquisitions and corporate
restructuring through advice (in return for high fees) and financing.
c. Investment banking also deals with converting loans and other assets into securities
(securitization).
The investment banking industry is roughly divided between those clients with more than
$ 1 bn in revenue, those in the middle market, and those in the smaller market with
revenues of around $ 25 million.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 24
Trends
Less business after the dotcom bubble burst
During the economic and stock market downturn of 2001-2002, fewer businesses
were interested in issuing new shares, which resulted in less income for
investment banks. Just prior to the slump, investment banks were increasingly
selling new shares particularly from those IT (information technology) companies,
which helped create the dot.com bubble. In 2004, after three years of
retrenchment, investment banking saw a rise in business again, party due to an
increase in equity underwriting.
31
More bonds
Issuing corporate bonds has been on the rise as investors are weary of the
unstable income from stock markets in recent years.
32
Moreover, bonds have
become a major instrument for corporations to raise capital rather than going to
the bank for loans. Companies that were at edge of bankruptcy have been issuing
junk bonds which were bought by investors willing to take high risks of losses in
case of bankruptcies, with sometimes high returns if the companies recovered.
33
Slow down and rise of mergers and acquisitions (M&A)
Many investment banks strongly promoted multi-billion dollar M&A, which during
the boom years inflated the stock market, and earned these investment banks
huge profits. Some financial conglomerates expanded their investment banking
operations during the ‘high’ times, at the expense of retail banking.
The benefits of M&As are not always obvious as many companies are left with
massive debts that are difficult to repay in an economic downturn (e.g. Vivendi),
while research shows that problems with merging corporate cultures and
management systems is known to contribute to more than 60% merger failure
rate. Recent corporate scandals at Ahold and Parmalat are, in some circles,
considered a consequence of expanding too quickly through M&A. Recently,
mergers and acquisitions have been on the rise again. In 2004, M&A were at the
highest levels since 2000, and this trend is likely to continue in 2005.
34
Prospectus with insufficient information
Investment banks offer a share prospectus to the public when shares are issued.
Due to problems of insufficient information for potential investors to assess the
price and value of the shares, more and more regulations have been legislated to
guarantee that investors are warned against the potential risks of losses.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 25
The role of banks in the collapse of Parmalat
Parmalat has been one of the world biggest dairy and food groups, with headquarters in Italy.
Its rapid expansion worldwide was first financed by loans from Italian and international banks.
Once the debt became too high, Italian and international banks arranged for issuing Parmalat
bonds. In December 2003, Parmalat could not repay its financial obligations and it became
slowly clear that it had been hiding losses and financial malpractices which are estimated at
more than Euro 12 bn.
Beginning 2004, Citigroup, Bank of America, Deutsche Bank and Morgan Stanley were being
accused of colluding with Parmalat executives in a scheme to hide the dairy group's massive
debt in order to inflate the value of the company's securities and bonds underwritten by the
banks.
35
The banks lay blame on the accountants' wrong financial reports, which inform banks
for their decisions.
36
In total, some 20 investment banks were involved in 40 bond issues mostly
through unregulated trusts in the Netherlands. They raised around $ 9 bn for Parmalat in 10
years from large and small investors.
An Italian executive of Bank of America is under investigation for having provided false
documents that informed accountants about an account that did not exist, and having set up
trusts that bought up the unsubscribed portions of private bond placements (to increase their
value).
37
Parmalat had different trusts in off shore centres.
Italian banks were by law not allowed to sell bonds to individual investors if those bonds were
issued only for institutional investors. However, the Italian banks were allowed to include those
Parmalat bonds in their mutual funds, which were bought by individual investors.
38
When
Parmalat collapsed, many Italians saw the value of their savings disappear.
Beginning 2004, some banks started to write off some of Parmalat's debt. Citigroup has set
aside $ 242 million for credit and trading losses (after taxes) related to Parmalat in 2003. The
total credits to Parmalat amounted to $ 653 million
39
but Citigroup had transferred the credit
risks to others for about half the amount.
In 2005, investigations were still taking place. Italian prosecutors were planning to bring to trial
Citigroup, Morgan Stanley, Deutsche Bank, UBS and the asset management arm of Banca
Intesa, for misleading investors and regulators in providing false information on Parmalat’s
financial position.
40
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 26
Critical issues
World Bank bonds
Many investment banks underwrite World Bank bonds, which are bought by
institutional investors including pension funds or funds managed by banks. The
World Bank gets 80% of its funds from the selling of its bonds. Many civil society
groups criticize World Bank’s “structural adjustment” programs that make World
Bank loans to developing countries conditional to all kinds of questionable
policies. A special network has been established to boycott the World Bank bonds
issues on private capital markets
41
.
Conflicts of interest between investment banking side and analyst side of
banks
Banks that underwrite and deal in issuing securities are often the same banks that
provide asset management services and advisory services to individuals or
institutional investors who buy securities. It has become apparent, after years of
rising stock markets, that some investment banks that assumed this dual role
have been misleading investors with biased research in order to win clients (see
box).
42
Some CEOs have been offered better-priced securities of new issues if they
bought additional banking services from the investment bank. Remember having
issued new shares, underwriters occasionally become members of the board,
which suggests closeness between the underwriters and the board of directors.
Investment banks, with inside knowledge of corporations, also reap the rewards
of high stock prices as well as of dumping shares in due time before they loose
their value, while the shareholding public is often left holding worthless paper.
Bursting of the dot-com bubbl
The stock market decline over 2001-2002 set the stage for growing queries regarding how
investment banks valued shares and how analysts from leading financial conglomerates
advised them. It was the collapse of energy trading company Enron at the end of 2001
that set off alarm bells due to falsification of balance sheets and corporate cover-ups by
one of the biggest auditors Andersen.
The scandal opened a floodgate of investigations into the overall standards and practices
of the American financial services industry, which drew into the fold the big auditors and
rating agencies. The world top investment banks such as Citigroup, Goldman Sachs, J.P.
Morgan and Morgan Stanley were fined huge amounts of money, paid in 2003, together
totalling more than $ 1.4 bn
43
, for conflicts of interest and generally misleading investors in
the US (see box). The banks had to restructure their operations and sever the analyst
division from the investment bank division by erecting a “Chinese Wall” to ensure the two
service divisions and employees never collude, and avoid further conflicts of interest and
corporate crime. Also in Europe, new rules and ways of operation for analysts have been
discussed.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 27
Scandals at financial firms
Manipulating the stock market
44
Citigroup, Goldman Sachs, J.P. Morgan, Morgan Stanley, Merrill Lynch and other top banks
paid a fine of US$ 1.43 bn to the US Securities and Exchange Commission (SEC) in April 2003
for the following malpractices in their investment bank services:
Conflict of interests: banks' securities analysts under pressure from colleagues to give
favourable advise to investors to buy shares from companies that were worth much less but
that were clients of other units of the bank. The favourable advise was a means to get, from
those companies, new highly profitable mandates for the investment bank unit to introduce new
shares or give advice on mergers and acquisitions.
Flipping: allocating new shares to a limited number of investors, and then selling those scarce
and highly demanded shares to the public, with high profits.
Laddering: the investment bank underwriting or introducing new shares requires brokers to buy
the new shares shortly after their introduction in order to keep their value high. In return, the
brokers are allocated extra new shares during the next introduction of shares. This kept the
value of shares, especially high tech shares, artificially high.
As a result of manipulating the stock market, shareholder wealth was reduced by 45% between
March 2000 and end of 2002, the equivalent of half of US GNP in 2000.
45
Manipulating bond markets
In the beginning of 2005, it became known that Citigroup had been involved in a major financial
scandal in August 2004. It had sold eurozone bonds worth of €12 bn, causing the prices to fall
dramatically. Traders of the bank later bought some bonds back at € 4bn, and this operation is
estimated to have made the bank a €17 million profit. Citigroup’s actions prompted criminal
investigations in Germany, and possibly inquiries in other countries follow. Citigroup has
apologized for the impact the trades had on financial markets, but claimed the deal “did not
violate any applicable rules or regulations”.
46
In March 2005, German prosecutors claimed they
could not legally establish a charge against Citigroup, since had to prove “an intent to deceive”,
and this had not been possible. Under a new German law on investor protection, which was
recently introduced, it will probably become easier to punish comparable actions
47
.
Undue privileges to rich clients (“spinning”)
Investment banks that introduced new shares gave CEOs of their client companies preferred
access to the new shares (from which the CEO could make personal gains) in return of new
investment banking mandates. For instance, in January 2002 Credit Suisse First Boston
48
paid
US$ 100 million to settle charges of this malpractice which has also been reported around the
world at many other banks.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 28
Bank malpractices at Bank of America (BoA), just an example
49
Failure to provide documents to the supervisors: the SEC fined a $ 10 m penalty in March 2004
because the bank provided misinformation and delayed or failed to produce documents
requested by the SEC for its investigation of illegal trading by the bank.
Alleged illegal trading in equities: the BoA was investigated beginning 2004 for allegedly taking
advantage of knowing future equity price movements that would follow the publication of equity
research briefings made by the bank’s own staff. By trading itself in equities just before the
publication of the research briefings, it could take advantage of its (insider) knowledge and
make extra profits.
BoA is being investigated by the SEC for allowing a client, a hedge fund, rapid trading practices
by lending its software to the client (see below: mutual fund scandals).
Parmalat: BoA was the house banker of the collapsed Parmalat and was involved in
fraudulently hiding Parmalat's huge debt through false statements (see box about Parmalat
scandal).
Developing countries pressured to sell too many bonds
Governments of many developing countries issue bonds to finance their deficits
and development plans. They are advised and sometimes pressured by
investment banks. After the 1997 financial crisis and after the IMF programme
was completed in 2003 the banks began to pressure the Indonesian government
to issue higher volumes of bonds, but the government hesitated for fear of
destabilizing the recovery with more debt.
50
Banks issue government bonds even in times of financial difficulty or crisis, which
raises questions as to whether banks properly assess the repayment capacities of
these governments. If the debts become too high and governments cannot repay
the bonds in due time, bond investors are pressuring to have payment of their
bonds prioritized. With no international agreement on orderly bond debt
restructuring or cancellation, the economy and poor people of a country suffer
most from the bond repayment obligations.
1.2.2. Private equity firms
51
Like investment banks, private equity firms raise funds for companies from private
investors. In contrast to the traditional operations of investment banks, they do not raise
money on public stock markets, but through direct intermediation between companies and
investors. Wealthy individuals or institutional investors like pension funds can invest their
money in a private equity fund, which the management directs towards companies. Many
large (investment) banks now have their private equity divisions. Their activities can be
divided in two main categories:
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 29
- Buy-outs: the buying of (parts of) companies that they perceive to be undervalued by
other investors, often because of troubles the company is facing, Private equity firms then
buy those companies, reorganize them with the aim of selling them at a higher price.
- Venture capital: the finance of starting companies often in fast-growing sectors.
Trends & Critical Issues
Major growth
The private equity market has grown enormously since the 1990s. In 2001, global
private equity investments market were at just below $ 100bn; in 2004, they had
risen to just over $ 300 bn. European investments accounted for half of the
investments, the US followed.
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What about accountability?
Through buy-outs, private equity firms buy firms of the stock market and get direct
control over the management of companies. What happens in the company
owned by a private equity firm is much less public than publicly listed companies,
for example due to the absence of disclosure requirements for privately owned
firms. Some have expressed their concerns over the lack of accountability as a
result. The private equity management can change the staff and personnel much
easier than would be possible in a company listed at the stock market, since there
are no shareholders they have to explain there policy to.
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1.2.3 Research, trading and brokerage
All kinds of firms are active in the intermediation of buyers and seller of securities. For
example, analyst houses and various research departments from financial firms sell their
services to investors who trade in securities or other assets including currencies, gold and
commodities. Financial firms also sell various trading services including executing orders
to trade and clearing securities trading.
Stock exchanges
It should be remembered that stock markets are also privately owned companies.
Worldwide, there are hundreds of exchanges. In practice, a few of them dominate global
markets, including the New York Stock exchange, the NASDAQ, the London Stock
Exchange, Frankfurt’s Deutsche Börse in, Euronext and Tokyo’s Stock Exchange
54
. As a
result of the globalisation of capital markets, and the increased competition from purely
electronic trading, there have been incentives for stock markets to cooperate or merge
with others. The Amsterdam, Paris and Brussels stock exchanges already merged into
Euronext. In the beginning of 2005, there has been much speculation on what is going to
happen with the London Stock exchange; Deutsche Börse and Euronext were contesting
a takeover.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 30
Critical Issues
Risks of stock exchange consolidation
The consolidation in the stock exchanges is said to bring more liquidity through
larger markets, and so increase efficiency. However, some have expressed their
concerns about the current mergers and takeovers. For example, some fear that
through a takeover of the London Stock exchange, competition on the European
continent between different stock exchanges will disappear, so that the prices for
– especially smaller - securities traders could increase. There should thus be
more supervision on stock exchanges at the European level, to guarantee a level
playing field
55
. The British Financial Services Authority expressed its concerns
over a possible takeover, since the London exchange could be moved to another
jurisdiction. In that case, other regulations would apply, and this could jeopardize
the current safeguards in place that protect both investors and companies listed
on the exchange
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.
Brokerage
Brokerage houses and brokers within financial firms are intermediaries between a buyer
and a seller and usually charge a commission. A broker who specializes in stocks, bonds,
commodities, or options acts as an agent and must be registered with the exchange
where the securities are traded (i.e. requires a license).
Trends and critical issues
Bias and market players
The research and analysis divisions of banks played an important role in
overvaluing and promoting certain securities, thus artificially inflating the stock
market, which has been dropping in a "slow crash" since end of 2001 (see box
above).
Profit even in bad times
Banks that offer brokerage services even profit when the stock market falls due to
the commissions they receive for selling orders from investors. During the Asian
financial crisis, the profits from securities' trading divisions of Dutch banks actually
increased.
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High salaries & bonuses
The exorbitant salaries and bonuses of those in the securities business have
been increasingly criticized, but to date, have never been addressed through
regulation. The difference between what traders and investors earn (those jobs
which are securities related) and those workers providing basic public services,
upon which a society is based, like teaching and nursing, reflects a serious,
ethical imbalance.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 31
Security lending
Securities are leased or lent to investors who then try to make a profit by trading
the leased security within the time of the leasing. Often leasing is done with
borrowed money, which can result in huge losses if the trading is not profitable. In
the Netherlands, for example, at the peak of the stock markets, there were
700.000 lease contracts outstanding, totaling an amount of € 6,5 billion. Many
investors faced enormous losses when the stock markets collapsed. Total losses
have been estimated at almost € 3 billion. The duped investors claimed they had
not been sufficiently informed about the risks informed. After a lawsuit, two
financial firms involved in the lease sales, had to pay almost € 1 billion
compensation to the investors.
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1.2.4 Derivatives services
Financial firms earn fees and are paid premiums for designing and trading in derivatives.
Derivatives are speculative contracts, whose value is derived from the future trade in an
underlying commodity, security or other financial asset. Examples of derivatives are
futures, options and swaps.
Derivatives bet against what a contract will be valued in the future. It offers for instance
protection against changes in commodity prices. Depending on the derivative, traders and
buyers take into account the performance of the asset, interest rates, currency rates and
various domestic and foreign indexes.
Because derivatives are both physically and temporally several stages removed from the
actual underlying commodities or financial instruments, to the outsider, they can be very
complicated in nature. Research found that institutional investors have an insufficient
understanding of the way companies use financial derivatives.
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Banks offer completely
custom made products by which the client is free to determine the derivative, using
variations in underlying currency, time to maturity, and payout structure (exotic options).
Options
On option is the right, but not the obligation, to buy (call option) or sell (put option) a
specific amount of given stock, commodity, currency, index or debt at a specific price (the
strike price) during a specific period of time. For stock options the amount is usually 100
shares. Each option has a buyer (called a holder) and a seller (known as the writer).
The buyer of such a right has to pay a premium to the issuer of the derivative (i.e. the
bank) and hopes the prices of the underlying commodity or financial asset to change so
that he can recover the premium cost. The buyer may choose whether or not to exercise
the option by the set date.
In practice, most call and put options are rarely exercised and investors sell or buy options
before expiration, speculating on the rise and fall of premium prices. For instance, when a
put option is exercised (e.g. at $50 a share) and the price of the underlying asset is much
lower in the market (e.g. $30 a share) at that time, the one with the right to sell can sell
and than re-buy the underlying asset at a lower price, making a profit (e.g. $20). Often,
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 32
option traders lose many premiums on unsuccessful trades before they make a very
profitable trade.
Futures
A future is a contract to buy or sell a specific amount of commodity, a currency, bond or
stock at a particular price on a stipulated future date. A future contract obligates the buyer
to purchase or the seller to sell, unless the contract is sold to another before settlement
date, which happens if a trader speculates to make a profit or wants to avoid a loss.
Currency swap
Simple currency swaps (swaps can be done with varying degrees of complexity) involve
two parties exchanging specific amounts of different currencies, as well as the interest
payments on the initial cash. Often one party pays a fixed interest rate while the other
pays a floating exchange rate. At the maturity of the deal the principal amounts are paid
back.
It allows the party, which is to receive currency in the future to calculate exactly what to
receive and avoiding exchange rate fluctuations. Swaps are also used to tap into new
capItal markets, sell currencIes on the InternatIonal market and borrow funds.
"Over the counter” (OTC) trading in derivatives
Over the counter derivatives trading is an exchange directly between the buyer and seller.
It is not listed on the exchange and is not traded through third parties.
Critical issues
Volatile business
Unexpected movements in the underlying value can negatively affect the value of
the derivatives. Derivatives became notorious in 1990s when a number of mutual
funds, municipalities, corporations and leading banks suffered large losses
because unexpected changes in interest rates affected the value of derivatives.
The trade in derivatives can have enormously destabilising effects on local
economies, because the use of derivatives allows speculators to move enormous
funds without actually owning them. In 1997, speculators used derivatives to
launch an attack on the Hong Kong dollar peg to the US dollar. They did this by
buying up large amounts of both foreign exchange derivatives and equity
derivatives with the aim of driving up interest rates and driving down share prices,
and ultimately breaking the peg, making them enormous profits. In the end, the
peg didn’t break due to Hong Kong authorities’ intervention in the equity and
foreign exchange markets
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.
Lack of regulation
Much of the trade in derivatives takes place in over the counter (OTC) markets, in
which there are often no transparency requirements in place. Governments and
market participants have thus no way of finding out manipulation practices or
other malpractices. In addition, derivatives can be used to evade tax law and
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 33
accountancy standards by manipulating the exact flows of payments in reporting
earnings
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.
1.2.5 Hedging
Hedging is investing in a particular way in order to reduce the risk of adverse price
movements in a security or asset. Hedging has been praised for helping companies avoid
unexpected financial shocks.
Hedge funds
Hedge funds are funds operated by an investment company, which use very speculative
strategies to obtain the highest possible return on their investments. They invest in all
kinds of very sophisticated financial assets, and then sell parts of this portfolio to investors
by issuing shares, much like any other company sells shares to the public. In practice,
hedge funds are thus only accessible for wealthy individuals and institutional investors, in
contrast to so called mutual funds who are accessible to regular households as well.
There is no formal definition of hedge funds, and between the thousands of hedge funds
that exist today, there are important differences. However, some general characteristics of
hedge funds can be identified
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:
Hedge funds get their name from the first hedge funds’ strategy to hold some
securities for a long-term period, and sell other securities after a very short time.
This combination is supposed to “hedge” the fund from risks associated with
changes in market prices.
Hedge funds use sophisticated strategies to increase the returns on their
investments. They invest in all kinds of financial assets like bonds, shares and
foreign currencies. In addition, they make extensive use of derivatives, financial
instruments whose value is based on the performance of other (financial) assets
(e.g. futures and options). Many hedge funds make these investments with
borrowed money. By using derivatives and borrowed money, hedge funds are
highly “leveraged”. This means that they finance their operations more by debt
than by money they actually own.
They apply extremely high minimum investment requirements. Most hedge funds
set extremely high minimum investment amounts, ranging from $250,000 to over
$1 million. In 2003 the mean minimum investment requirements of global hedge
funds were $630,414
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.
Customers of hedge funds pay the management a fee based on the assets they
have put into the fund (around 1-2%). In addition, they pay the management a fee
based on the performance of the fund (around 20%). Fund managers normally
also make significant investments in the fund. Often, hedge funds also invest in
other hedge funds to increase potential returns (“fund of hedge funds”).
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 34
Trends and Critical issues
Industry has grown enormously
Hedge funds have grown enormously since their rise in the 1950s. Increasingly,
not only wealthy individuals but also institutional investors like pension funds have
invested in hedge funds or less speculative hedge instruments offered by financial
firms in search of better returns than those from traditional mutual funds. In 1994,
total US hedge funds assets were US $ 99 billion, ten years later this was US $
795 billion.
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Risky strategies
Hedge often take large risks on speculative strategies, including in markets with
sharply declining prices. Because they move billions of dollars in and out of
markets quickly, they can win enormous amounts, but of course they might also
loose them. If they loose money, they often loose the money of banks they borrow
from. The most notorious example of this was the 1998 failure of the US based
‘Long Term Capital Management’ (LTCM) fund. To avoid a systemic financial
crisis, the US central bank intervened, injected billions of dollars in the fund and
took over its management.
Hardly any regulation
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Hedge funds are exempt from many of the rules and regulations governing
regular investment funds. They are often managed in the US or another European
country, but ‘domiciled’ in offshore centres, i.e. small countries and islands where
there are no regulations in place, and no taxes to be paid. Important offshore
centres for hedge funds are the Bermuda, Caribbean and the Canal Island
Guernsey. Hedge funds are in practice thus not required to publish data on their
trading activities and their creditworthiness like any other financial institution.
After the notorious LTCM collapse, international bodies like the IMF, the Basle
Committee and the Financial Stability Forum, increasingly started to discuss
possible regulations. More recently, the SEC (the US Securities and Exchange
Committee) has been discussing more concrete regulation proposals.
No sustainability indicators
Hedge funds do not pay any attention whatsoever to the social and environmental
impacts of their investments.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 35
Hedge funds, some controversies
Hedge funds are important speculators on financial markets. Speculation means that an
investor trying to make profits by gambling on changes in the price of a security. When he buys
an asset, a speculator thus doesn’t intent to keep it, he just buys it in order to sell it at a higher
price in the near future. Examples include currency speculation: an investor (or fund) expects
the value of a certain currency (say the Euro) to increase in a month time, and therefore buys
huge amounts of euros. When indeed that price has risen, he can sell the euros at a higher
price.
Because of the enormous amount of funds they manage, hedge funds often also aim to
influence prices by using their market power. Hedge funds can coordinate their actions, and
persuade other market actors to follow them.
Market manipulation is an illegal activity hedge funds have sometimes found guilty of. It means
that they try to influence the prices by spreading misleading information that will probably affect
other investor’s demand for a security. This change in price can lead to enormous profits for the
funds.
Adverse impact on local economies
Hedge fund’s impact on local economies can be enormous. For example, if hedge fund
managers expect a currency to depreciate, they can start to sell their holdings of the currency
in question. Often, other market participants follow the funds with high reputation, and this
further drives down the prices of the currencies. Central banks are often not able to counteract
these speculative forces. Because their gigantic size, and their influence on other market
actors, hedge funds can make or break currencies. A notorious example of this was the attack
of the hedge fund manager George Soros on the English pound in 1992. By speculating on a
depreciation of the currency, the fund forced the British currency out of the European system of
fixed exchange rates. Other examples include the speculative attack on the Thai Baht and
other South Asian currencies 1997, which led to dramatic aggravation of the Asian crisis.
Frauds at hedge funds
Hedge funds have sometimes been blamed of manipulating market prices, which
disadvantages smaller investors. For example, they make other investors believe a company is
doing very well, and this will make the price rise. After this, hedge funds sell their holdings of
these securities and make a huge profit. Retail investors are duped by this, since they only see
the value of their holdings plunge. There also have been cases of funds misleading their own
investors.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 36
1.2.6 Asset management
Asset Management (also called money management, investment management) is simply
the process of managing all kinds of investments, budgeting, financing and taxes. An
important part of asset management takes lace at pension funds, mutual funds and
insurance companies, as described below.
Financial firms earn fees by providing services (investment advice, investing funds,
derivatives) to corporations, wealthy individuals and institutional investors regarding the
management of their capital and other assets. Their job is also to insure their clients get
the highest rate of return.
1.2.7 Pension funds
Pension provision is organised in different ways. Sometimes retirement benefits are paid
from contributions of current employees (so-called pay-as-you-go financing).
In other systems, mainly in the US, and European countries like the UK and the
Netherlands, funded schemes are more common, in which contributions are accumulated
in a fund until the person retires. A pension fund can be set up by a company,
governmental institution or labour union. The management first collects pension benefits
from workers and their employers, and invest this money in all kind of assets. Because the
funds have collected money of up to millions of individuals, they are major players on
financial markets.
The fund managers make actuarial assumptions about how much they will be required to
pay out to pensioners and then try to ensure that the rate of return on their portfolio
investments equals or exceeds that anticipated pay-out need. Pension funds or pension
insurance companies often delegate the actual investments to financial firms such as
investment houses or banks
Trends & Critical issues
Dominant players on the market
Pension funds buy all kind of securities on the international markets. Their
purchase of shares has helped create a bubble of high share prices partially
because the pension funds have hundreds of billions of dollars to invest. Once the
stock market starts to fall, the pension funds try to reorganize their portfolios,
which contributes to the rapid decrease in share values (since they move so
much money at once).
Losses due to stock market decline
In countries such as the UK or the Netherlands, regulators do not restrict pension
funds from investing heavily in the equity market (unlike in Germany). This means
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 37
that large portions of Dutch and British pensions are invested in listed, both
domestic and foreign, companies. With the fall of stock markets, pension funds
have lost billions of dollars and Euros in the last few years and now many cannot
guarantee that they will pay out 100% of the promised pensions to their
contributors in the future. Pension fund supervisory authorities have had to
intervene to force pension funds to come up with strategies to ensure all future
payment obligations. Consequently, pension funds have been switching to the
bond market, which is a more secure source of income for their long-term
obligations.
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Additional income for pension funds generated by increasing the
contributions made both by employees and employers is decreasing workers
income and companies profits. Some pension funds however are restructuring
and merging while another strategy has been to turn to hedge funds and
corporate bonds, which could bring higher yields but which have also a high risk
of failure.
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Little attention to ethical indicators
Pension funds have traditionally cared little about investing in securities of
companies that are considered ethical or environmental, i.e. have a positive effect
on the environment or that respect labour rights and human rights (see chapter
4). In the Netherlands, for example, only 1% of pension funds’ money is estimated
to be directed to sustainable investments.
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1.2.8 Mutual funds
Mutual funds are funds operated by a bank or an investment company that invest their
money in a group of assets, including shares in various companies, bonds, options,
futures, currencies, or money market securities in accordance to a stated set of objectives.
They then sell parts of this portfolio to investors- households but also institutional investors
- by issuing shares much like any other company sells shares to the public. A mutual fund
can be more attractive to investors than individually composing a portfolio of assets. This
is the case since their money is managed by professional asset managers, and their
portfolio is very diversified to reduce risks. A management fee is charged for these
services. All shareholders share equally in the gains and losses generated by the fund.
Trends
Booming business…
Banks and investment funds have created a variety of mutual funds that invest in
specific countries or sectors. The increasing prices of the stock market had
attracted a lot of individual and institutional investors to buy units of mutual funds,
providing banks and mutual funds with high income from the management fees.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 38
Losses after the stock market bubble
Lower stock prices in 2002-2003 decreased the value of mutual funds
substantially. In some cases investors have lost up to 50% of the value of their
units. Some mutual funds and banks providing those services lost a significant
source of income, which resulted in some mutual funds closing down completely.
In 2003-2004 the mutual fund industry started to grow again. As of December
2003, the mutual fund business in the US was valued at US$ 7,000 bn and 8,000
bn beginning April 2004.
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Scandals at mutual funds
70
The following practices are calculated to have cost the individual US investors (95% of the
population) $ 10 bn:
Late trading and market timing: transactions after 16 hours, the official closure of trading mutual
fund shares, which allows advantages to be taken by price differences between old share
prices and new prices of the next day, or between different international stock exchanges in
different time zones.
Rapid trading and market timing: mutual funds have allowed big investors, mainly hedge funds,
to rapidly trade of shares of international mutual funds in a way that takes advantage of
discrepancies in asset values across time zones. This siphons off profits at the expense of
long-term investors. Although these practices are not necessarily illegal, 22 US mutual funds
have been investigated by the US Securities and Exchange Commission in 2003 and have
changed staff. The highest fine had to be paid by Alliance Capital, $ 250 million. Bank of
America is also under investigation.
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Individual fund managers have also been sentenced.
Just one fund manager was able to make a profit of $ 600,000.
Improper sales practices: Morgan Stanley had to pay a $ 2m fine for improper incentives (such
as exotic travel trips and tickets for Rolling Stone concerts) to its sales staff to push their own
mutual funds to clients over other mutual fund products (non proprietary funds).
Too high fees: the costs for managing mutual funds were untransparent and mutual fund
charged clients too much for it.
As a result of the malpractices in the US, the European securities supervisor (CESR)
conducted a survey on the situation at European mutual funds. They didn’t find major
malpractices, however, the report concluded there were “issues of regulatory concern”. For
example, fund managers said they were sometimes approached by investors to allow market
timing and late trading, and in the absence of clear procedures and responsibilities, the
existence of those practices could not be excluded
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.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 39
Critical issues
Destabilising impact on local economies
Because of their size, like hedge funds, mutual funds’ investment decisions have
an enormous impact on local economies. In the mid 1990s, mutual funds bought
heavily into securities of emerging markets. This dramatically affected the upturns
and downfalls of those economies. It is the quest for short-term gain or quick
profit which motivates funds and traders to buy and sell quickly, regardless of the
impact on the societies in countries in which they invest and the long-term
benefits which are lost.
For example, the appetite for investments in emerging market countries (EMCs),
was dramatically curtailed by the Asian Crisis of 1997, the Russian default and
subsequent near financial meltdown of 1998, the resulting problems in Brazil and
elsewhere, and the collapse of the Argentine economy (2001-2003). When mutual
funds and traders in securities quickly withdrew securities from countries in
financial crisis, their actions further decreased the value of all securities. This was
the case in South East Asia, and this helped exacerbating the overall financial
crisis.
The lack of transparency in pricing (see box)
The lack of transparency and clarity between the cost of to manage the fund and
the management fee charged to clients has lead to various pricing scandals.
Fund managers are also increasingly under investigation for not abiding by
trading rules including trading after the cut-off time (late trading). These scandals
have lead to lawsuits and indictments because of overcharging, which have made
some mutual funds more accountable to investors.
Growth of ‘ethical investments’
So-called green funds and ethical funds are popping up all over the place.
Mainstream mutual funds are also increasingly offering these ethical investment
options. This growth highlights an increased attention of investors for sustainable
development. Growth of these investments can also be facilitated by government
regulations. For example,
in the Netherlands,
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investors are exempt from interest and dividend income tax
coming from green funds that fulfil environmental criteria laid down by the
government. The tax exemption is intended to compensate the lower interest
rates and dividends of those green shares, and the system seems to work fairly
well. In fact, Dutch green funds, worth around a billion Euros, have been so
popular that there have not been enough green projects to finance. Investors
have to queue-up before joining the green fund, which indicates that citizens do
invest in green funds if they have the choice, and that a tax incentive can create a
strong demand for such funds.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 40
But … lack of clear indicators
Marketing ethical investments is a ‘growing trend’ as the general public learns
more about the connections between the stock market, pension funds and other
investments. However, clear, widely adopted standards or green funds and ethical
funds do not exist. Therefore green fund managers, and governments in some
cases, are setting their own terms of reference. Most mutual funds managers
continue to focus only on the bottom line, or the company’s financial and
economic performance rather than its contribution to environmental sustainability
or commitment to human rights. Civil society groups thus continue to be critical of
many ‘so called’ ethical or green investment assessments.. (For further analysis,
see chapter 4)
1.2.9 Trust services
Banks can provide trustee services and services for the formation and management of
companies that are either special purpose companies, holding, trading, finance or royalty
companies belonging to an international group, or privately owned offshore companies.
Normally the shareholders, management and statutory seats of such companies are
spread over, at least, two countries.
Trustee services include services necessary to fulfil all legal and other requirements to
keep a company in good standing however, most of these companies, which are provided
by banks, are created to evade tax. They are mostly "post box companies" in countries
with relaxed tax regimes and little investigative supervision or regulation.
Critical issues
Trustee services are invisible but have major impacts
Bechtel:
Bechtel formed a consortium that was officially based in the Netherlands. In
reality the consortium was just a "post box company" managed by ING Group's
Trust services in the Netherlands. This consortium bought the privatized water
services of Cochabamba in Bolivia. Following the intense civil unrest and protests
due to the rising water prices privatization was reversed. The consortium tried to
win compensation through the investment protection provisions of the bilateral
investment agreement between Bolivia and the Netherlands.
Parmalat:
Trustee services are often seen as purely administrative support for a ‘staff-less’
company (i.e. postal address only). However in the case of the scandalous
Parmalat (Italian milk and food conglomerate) the trust units were both in off
shore centres and in the Netherlands. Those companies in the Netherlands were
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 41
responsible for issuing billions of Euros in bonds, which, now we know, will not be
repaid. The Parmalat trustee service responsibilities proved difficult to clarify.
1.3 Rating services
A rating agency is a company that is specialized in evaluating the capacity to repay debt
(“creditworthiness”) of companies and governments. Most often they give ratings to debt
instruments like corporate and sovereign bonds, but it can also concern commercial loans.
The rating is expressed by a code, ranging from AAA as the highest creditworthiness, and
C or D as the lowest. Rating agencies earn their money by charging a fee to the
companies and governments they rate, and by selling their findings to the public.
Currently, there are over a hundred credit rating agencies operating worldwide. However,
in practice, three of them dominate the market: Standard’s & Poor, Moody’s and Fitch
Ratings. All three of them are based in the US.
Currently, investors often don’t even accept bonds from companies and governmental
institutions that don’t have a rating from one or more of the major rating agencies.
Companies and governments who wish to borrow on capital markets thus are completely
dependent on private firms who will rate their creditworthiness. Given this dependence on
having a rating, borrowers are willing to pay substantive amounts of money for this. For
borrowers, the fees for obtaining a rating can be over a million US dollars.
Trends and Critical issues
Increasing power
The role of rating agencies has increased especially since corporate and
sovereign bonds got more common. With borrowers heavy reliance on their
ratings, many companies and governments are very concerned about the
judgements of ratings agencies. A change in ratings can make or break investors’
confidence, and will enormously raise borrowing costs. Some institutions’ financial
portfolio is directly dependant on ratings of the big rating firms. For example,
pension funds are often only allowed to hold bonds rated at investment grade,
which is not below Baa/BBB (see box). A lowering in rating can thus have an
enormous effect if institutions like pension funds have to sell those assets. In the
future, the power of rating agencies will only increase when a new international
regulatory framework for banks will be in place (“Basel II”). According to the Basel
II framework, banks can use ratings of private rating firms’ or public institutions
like ECA’s to determine how risky loans will be, and thus how much interest
borrowers will have to pay. (see chapter 5)
Conflict of interests
Private rating agencies get paid to give a company or state a rating. Rating
agencies stress that it is in their own interest to remain completely independent,
since their sound reputation is key in attracting business. However, in the
absence of many competitors, conflicts of interests may still arise.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 42
Failure to adequately rate borrowers
Rating agencies have often proved not to be able to anticipate decreasing or
improving creditworthiness of borrowers. A major example was the collapse of
companies like Enron and Parmalat. According to rating agencies just prior to
those companies’ collapse, bonds of those companies didn’t contain much risk of
default. Only after it became public in how bad a financial state the firms were, did
the agencies lower their rating. For example, Standard & Poor, one of the major
rating agencies, continued to give Parmalat a high rating until December 2003,
despite the fact that the 10 billion Euro fraud was becoming public knowledge.
The same happened during the Asian crisis. Prior to the crisis, ratings were at
reasonable levels. When the crisis erupted, rating agencies dramatically lowered
the ratings of the countries concerned, which according to many further
aggravated the crisis because more investors immediately pulled out of the
region. In case of South East Asia, the financial crisis could possibly have been
mitigated if rating agencies warned creditors and the foreign banks of the
approaching lack of capacity to make repayments in foreign currencies.
No sustainability indicators
To date, rating agencies do not include any information about a company’s
environmental and social behaviour in their rating assessments. There exist
specific rating agencies that aim to take these social and environmental issues
into account, and give a company a rating on this basis (such as SiRi company,
see chapter 4). However, they rate all kinds of companies on sustainability
grounds, but do not combine this with an assessment of their capacity to repay
debts. Thus, they will not have a substantive impact on creditors looking for
information on creditworthiness.
1.4 Insurance services
Insurance is a promise of compensation for specific potential future, unexpected losses in
exchange for a periodic payment.
Agreeing to the terms of an insurance policy creates a contract between the insured and
the insurer. In exchange for payments from the insured (called premiums), the insurer
agrees to pay the policyholder a sum of money upon the occurrence of a specific event. In
most cases, the policyholder pays part of the loss (called the deductible), and the insurer
pays the rest. Examples include car insurance, health insurance, disability insurance, life
insurance, and business insurance.
Premiums are determined on the probability of risk as well as competition with other
insurers. Generally, insurance spreads out the risk (of potential claims from individuals
and companies) to a larger group whose sums are better able to pay for losses.
Insurance policies are often sold to individuals and companies through insurance agents
who are licensed representatives of one or more insurance company, or through
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 43
independent insurance brokers who search for the lowest cost for the client by comparing
competing insurance companies.
Forms of insurance to individuals include:
Personal property insurance: Such as automobiles, homes; the insurance policy
specifies which property, accidents and casualty perils, theft and other damages
are covered.
Life insurance: Guarantees payment to the beneficiaries when the insured person
dies. The insurance policy spells out whose life is insured and which beneficiaries
will receive the insurance proceeds.
Health insurance: The policy specifies which medical treatments and drugs are
reimbursed.
Insurance services to corporations protects against:
Liability: e.g. of board members, environmental damage
Property damage to, and loss of e.g. computers, transported goods
Losses that endanger the continuity of the company’s activities: e.g. of computer
data
Fraud and other financial problems
Extra payments for employees: e.g. for long term illness, accidents, absenteeism,
pensions, unfair dismissal, sexual harassment, discrimination
Transport
Blackmailing
Reinsurance is the sharing of insurance policies among multiple insurers and selling
securities on the market. Reinsurance companies (e.g. the German Munich-Re) are
specialized in insuring the insurance industry.
Export credit insurance
A special form of insurance is the insurance of export payments. All industrialized
countries have one or more export credit agencies (ECA) that will pay for potentially
missed export earnings. In recent years, many of those agencies have been privatized.
If a company is exporting to another country, and will receive the money only after the
export has been finalized, it can request an export credit at a commercial bank. If the bank
is not sure whether it will receive the payments for the goods exported to the country in
question (e.g. when it concerns poor countries), the bank can get an insurance against
this risk.
Trends & Critical issues
Disappearing reserves
The European insurance sectors are facing the same problems as the pension
funds, namely lack of funds. European insurance companies invested heavily in
the equities and derivatives markets but with the economic downturn over the last
few years, insurance companies lost a significant portion of their assets, which
has affected their ability to pay out for claims (see also chapter 2).
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 44
The situation is so critical that governments concerned about the solvency of
insurance companies (one Germany insurer already went bankrupt) are
increasing supervision and tightening regulatory systems, which is a sign that
even big European private insurance companies take too many risks and need
more regulation and supervision.
Insurance companies are still vulnerable especially if the stock market and the
economy continue to weaken.
74
Action on climate change
Increased claims for environmental damages due to erratic weather, has meant
that some insurance companies have begun specializing in climate change
related damages. They have an important analysis and databank capacity on
climate change phenomena. Some (e.g. re-insurer Munich-Re) educate others in
the financial industry about the importance of quelling climate change.
Targeting the rich in developing countries
Western insurance companies enter developing countries and sell private health
insurance products to those who can afford the policies, in many cases leaving
the government and domestic private insurance companies burdened with the
poor patients. The question remains if the presence of Western insurers in poor
countries help increase general access to health insurance?
75
Equity funding
Equity funding is an investment, which combines a life insurance policy with
shares in a mutual fund. The fund shares are used as collateral for a loan to pay
the insurance premium, giving the investor the advantages of insurance
protection and investment appreciation potential. These advantages disappear if
the value of the mutual fund does not increase.
Scandals in the insurance industry
In 2004, investigations of the New York attorney-general Eliot Spitzer revealed
some major scandals at US insurance companies and brokers. These brokers are
the intermediaries between buyers and sellers of insurance products and make
money by charging both parties a commission. It became apparent many US
insurance brokers and insurance companies were collectively betraying
customers by charging too high premiums. Insurance firms offered brokers so-
called “contingency-commissions” – commissions that are only paid if the broker
delivers a certain amount of clients to the company. This has lead to many
manipulations, as brokers have eagerly accepted these offers, and have
sometimes even threatened to destroy an insurance company if they didn’t get
extra commissions.
Among the companies found guilty was Marsh & McLennan, the biggest
insurance broker worldwide. In 2003, income out of contingent commissions
accounted for $ 845 million of the groups turnover. Since the end of 2004, the
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 45
company has had to change its business model and doesn’t accept the
contingency commissions anymore
76
.
The world’s biggest insurance company, American International Group (AIG), has
also been under heavy investigation. It became apparent that there had been
many irregularities in the company’s financial reporting. The chief executor,
Maurice Greenberg, already had to resign. In addition to these reporting
practices, AIG has also been accused of market manipulation. Just prior to AIG’s
takeover of American General in 2001, Greenberg is said to have pressured
traders of the New York Stock Exchange to buy AIG shares in order to boost the
stock price.
77
Private risks turned into developing countries’ debt
78
When a developing country importer fails to pay for its imports, the exporting firm
or bank who provided an export credit, will be compensated by the ECA
concerned, minus a small percentage of own risk. In case the ECA also fails to
get this money back, they will simply add this amount to the developing countries’
official foreign debt. In this way, private risks are being transferred to developing
countries’ and of course, eventually its taxpayers.
The share of ECA debt of total official debt is enormous; in 2002 it is estimated to
account for 34 % of total external official debt to aid receiving countries ($
368,503 million of $ 1,064,718 million). Sometimes, ECA debts are even based on
controversial exports such as weaponry. In this case, industrial countries’ exports
of weapons to developing countries have to be paid for by the importing country
(and eventually its taxpayers, who have often been the victim of the use of these
weapons).
Many civil groups have been pressing for reforms of ECA’s, and for debt relief of
the ECA debt. Aid organizations point out that it is crucial that this debt relief that
Western governments do not deduct the ECA debt relief from the official
development aid (ODA) budget, as is often the case in many industrialized
countries. They state that cancellation of debt that arose from private sector risk
should never reduce the budget for true development aid.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 46
1.5 Conclusions from the perspective of poverty
eradication and sustainable development
1. Financial services focus on big companies and the rich
Most "products" of the financial services' firms service large companies and investors, not
individuals and governments. A key strategy at banks is to target their services at the most
profitable clients or institutional investors and companies, leaving the less wealthy at a
severe disadvantage. At the same time, they create huge debts by companies and
individuals.
In some countries, ‘market segmentation’ has resulted in the closing of branches and the
exclusion of poor clients through a reduction of basic services and the compulsory use of
computerized transaction services. Small and medium enterprises, which are vital to the
economy, are treated less favourably than those big corporations that are offered better
interest rates.
That banks are driven by profit and increasing pressure from international competition,
means that poorer clients could require more legal protection against limited and poor
quality service. Market forces will not ‘naturally’ help poor clients when they are at such a
structural disadvantage.
2. Governments are clients of the financial industry
The financial industry is heavily involved in government debt through loans, syndicated
project lending, debt derivates, trading in debt and underwriting and trading in government
bonds.
The funds for conditional lending to developing countries by the World Bank come largely
from bonds underwritten and traded by investment banks. Financial firms often jointly fund
projects supported by the World Bank. This dependence of financing by private financial
firms might challenge the regulatory independence of governments, especially in
developing countries.
3. Manipulating financial markets
The financial industry played a significant role in creating the stock market bubble, which
slowly crashed from 2001 to 2003. The industry was instrumental in increasing stock value
through services such as:
investment banking (new shares on the stock market),
analysis, research and advisory services for those investing in the stock market,
including pension funds,
trading and brokerage in securities, including derivatives and share lending,
mutual funds for both small and large investors, making investment in equities
more accessible,
selling hybrid financial products in which, for instance, loans and insurance were
combined with investments in equities.
In addition, financial firms were manipulating share prices by releasing wrong advise to
benefit companies that were or could become their clients. The seriousness of the fraud is
evident from the US$ 1.4 bn fine by the Securities and Exchange Commission to large US
banks. Some mutual funds also over charged clients and traded illegally.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 47
In bond markets, market manipulation is also not unusual, as the Citigroup scandal
highlights (see box 1.2.1 ‘scandals at financial firms’).
The heaviest burden of the fall-out from the artificially high value of the financial market
has been on individual investors (including pensioners), pension funds, insurance
companies, and companies from the developing countries.
4. The efficiency of the financial industry far from accomplished
Some major failures of the financial industry disclosed over the last decade are:
Concentration at European banks: A recent study showed that European banks
are not very well diversifying their portfolio to reduce risks. They often have a
small number of big clients they concentrate their activities on, and in case of a
default, this could easily endanger a bank’s financial position
79
.
Some pension funds invested heavily in the stock market and with the crash,
cannot now guarantee fully delivering peoples’ pensions. Should pensions in
developing countries be privatized and subject purely to unstable market forces?
Financial reserves in the European insurance industry have been reduced to
dangerously low levels due to over-investment in the stock market and far-
reaching crises including, environmental disasters, terrorist attacks and corporate
scandals.
Rating agencies often failed to provide warnings on financial problems at
governments and companies. Artificially inflated ratings encouraged the financial
industry to continue investment in governments and companies with dubious
financial state of affairs.
When mutual funds and traders in securities quickly withdrew securities from
countries in financial crisis, as was the case in South East Asia, their actions
further decreased the value of all securities thus exacerbating the overall financial
crisis. It is the quest for short-term gain or quick profit which motivates funds and
traders to buy and sell quickly, regardless of the impact on the societies in
countries in which they invest and the long-term benefits which are lost.
Investment banks increasingly underwrite bonds from loss-making companies
and many small investors are loosing their money. The investigation of the role of
large banks in the hiding of Parmalat's debt of more than Euro 12 bn, is a clear
example.
5. Unknown effects of little known financial services
The financial industry is trading in and designing new and more complex financial
products, which are less and less transparent and difficult to monitor. Increasingly, the
risks involved with these speculative services are becoming more unpredictable for both
the consumer and the authorities.
For example, the increased popularity of credit derivatives, which transfer banks’ lending
risks to speculators and institutional investors, including insurance companies, is a trend
closely monitored by the authorities. Passing off or selling risk, particularly with credit
derivatives, is potentially the basis for financial crisis, which should be a concern for civil
society and the authorities.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 48
1
Except otherwise indicated, the explanation of the financial terminology in this chapter is based on, or
taken from: J. Downes, J. Elliot Goodman, Dictionary of finance and investment terms, (Barron's
Financial Guides), Sixth Edition, 2003; R. Lister, L. van der Deijl, A handbook of commercial and
economic terms, English-Dutch, (Intertaal), 2001.
2
Deloitte & Touche Research, How to Make Customer Loyalty Real, 1999.
3
See for instance J.P. Morte, Consumer Banking, in Business World (Philippines), 7 July 2003
4
T. LoFrumento, How profitable are your customers?, 2003 Bell & Howell Information and Learning,
April 2003, p. 24-31.
5
Erica Verdegaal, Winkels, consumenten en banken kunnen niet zonder elkaar. Knelpunten en
oplossingen bankdiensten in kaart gebracht, in DNB Magazine, De Nederlandsche Bank, no. 1, 2005
6
Makeover and make money, in The banker, 2 December 2003.
7
CELENT, Cross-selling in European retail banking: strategic lessons for incumbents, press release,
Paris, 27 August 2001.
8
In Belgium at least 40.000 of those living on minimum wage have problems accessing basic financial
services according to: Banken zouden in Belgie 40 000 personen uitsluiten: een enquete, in S.E.E.
Newsletter - Social & Environmental Efficiency, nr. 23, 26 December 2001.
9
UvA-student wint national scriptieprijs, in Folia 21, 56th year, 31 January 2003, p.6.
10
J. Slagter, Ook klanten van banken moeten iets te kiezen hebben, in Het Financieele Dagblad, 4
December 2001.
11
Mass panic grips Zimbabwe banks, 15 January 2004, at http://news.bbc.co.uk/go/pr/fr/-
/2/hi/africa/3400369.stm
12
J. Authers, Mexicans send more than $ 1 bn back home in July, in FT, 19 September 2003.
13
N. Instefjord, Risk and hedging: do credit derivatives increase bank risk?, at
http://www.econ.bbk.ac.uk/faculty/instefjord.html, p. 5.
14
BIS, Sovereign credit default swaps, in BIS Quarterly Review, December 2003, p. 79.
15
For more information see: www.credit-deriv.com
16
The definition is a simplified version from I. Marsh, What banks can learn about default risk from credit
markets, in Market functioning and Central Bank Policy, BIS Papers nr. 12, August 2002, p. 330; and
N. Insterjord, Risk and hedging: do credit derivatives increase bank risk? At
http://www.econ.bbk.ac.uk/faculty/instefjord.html, p. 4; J. Kiff and R. Morrow, Credit derivatives, in Bank
of Canada review, Autumn 2000, p. 4.
17
For a detailed survey on credit risk transfer and its potential risks, see The Economist, How is carrying
the can?, Special Report: Bank Lending, August 16
th
2003
18
BBC World Service, 13 January 2004.
19
Ethnic minority business in the UK: Access to finance and business support - A report by the British
Bankers Association, quoted in Marketing International, 22 January 2003, p. 10.
20
www.socialfunds.com/news/article.cgi/article1073.html: the report America's best and worst lenders: a
consumers' guide to lending in 25 metropolitan areas covering 2000 and 2001is made to reinforce the
US Community Reinvestment act which is often not respected.
21
S. Jung-a, A. Ward, Plan to ease rules sparks warning, in FT, 30 September 2003.
22
Financial Times, articles in December 2003 and January 2004.
23
Visakaart als hebbeding, in NRC Handelsblad, 28 August 2003.
24
See J. Kiff and R. Morrow, Credit derivatives, in Bank of Canada Review, Autumn 2000, p. 8-10.
25
N. Instefjord, Risk and hedging: do credit derivatives increase bank risk?, at
http://www.econ.bbk.ac.uk/faculty/instefjord.html, p. 0.
26
Financial Stability Forum, Statement by Roger W. Furgerson, JR., Chairman of the Financial Stability
Forum, International Monetary and Financial Meeting, 21 September 2003.
27
The Economist, How is carrying the can?, Special Report: Bank Lending, August 16
th
2003
28
I. Marsh, What banks can learn about default risk from credit markets, in Market functioning and
Central Bank Policy, BIS Papers nr. 12, August 2002, p. 338.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 49
29
See for instance: A. Hoog, Nallie Bosman: CEO, ABSA Bank, in Moneyweb (South Africa), 2 June
2003.
30
J. Slagter, ABN Amro trekt Braziliaanse sloppenwijken in, in Het Financieele Dagblad, 9 October 2003.
31
Peter Thal Larsen and David Wighton Investment banking 2005. Record earnings as sector recovers,
in FT January 27 2005
32
Under the regulatory yoke, in FTfm, 19 January 2003, p. 28.
33
J. Wiggins, Low interest rates help lift performance, in FT, 8 December 2003.
34
The Economist, Love is in the air, February 5
th
2005
35
E. Backus , F. Kapner, Parmalat plaintiffs put hopes in US justice, in FT 11 March 2004
36
J. fuller, No one attempted Parmalat jigsaw, in FTfm, 19 January 2004, p. 6.
37
F. Kapner e.a., BofA offices raided in hunt for Parmalat's missing billions, in FT, 10-11 January 2004.
38
Information from Andrea Baranes (Campagna per la reforma della Banca Mondiale, Italy)
39
Ook Citigroup schrijft fors af op leningen aan Parmalat, in Het Financieele Dagblad, 21 January 2004.
40
FT, Parmalat prosecutors ready to request charges, February 14
th
2005.
41
See for more info on the WorldBank bonds boycott, http://econjustice.net/wbbb/
42
Citicorp 4th-qrt profit rises 96% to 4.76 billion (update 3), Bloomberg.com, 20 January 2004
43
See box: Scandals at financial firms
44
G. Hettinga, Zakenbanken op strafbank, in Effect, 2003, nr. 1; Bloomberg, Citigroup, Morgan Stanley
CEOs risk SEC penalties, 06/04/03
45
BIS, 73rd Annual Report, p.102-103.
46
Citigroup, Joint Statement by Tom Maheras, CEO, Global Capital Markets and William Mills, CEO,
Europe, Middle East, & Africa, Citigroup Corporate and Investment Banking Group, Citigroup Press
release, February 02, 2005, through ww.citigroup.com
47
Païvi Munter and Charles Batchelor, Citigroup cleared of bond market offence, in FT, 22 March 2005
48
A. Michaels, D. Wells, JP Morgan in $ 24m settlement, in FT, 2 October 2003
49
A. Michaels, SEC slaps $ 10 m penalty on Bank of America, in FT, 11 March 2004; D. Wells, Bank falls
foul of family favourites, in FT, 5 March 2004.
50
S. Donnan, Jakarta set to appoint banks for bond issues, in FT, 19 January 2004.
51
This section is based on The Economist, Private equity, Size matters, January 29
th
2005 ; Paul
O’Keefe, The Rise of the new conglomerates, BBC Radio, In Business, February 10
th
21.30, online at
http://news.bbc.co.uk/1/hi/business/4249673.stm
52
The Economist, Private equity, Size matters, January 29
th
2005
53
Paul O’Keefe, The Rise of the new conglomerates, BBC Radio, In Business, February 10
th
21.30,
online at http://news.bbc.co.uk/1/hi/business/4249673.stm
54
See Stijns Claessens, Thomas Glaessner, Daniele Klingebiel, Electronic Finance: Reshaping the
Financial Landscape around the World, Table 2, Worldbank Financial Sector Discussion paper no. 4,
September 2000
55
NRC Handelsblad, Vd Moolen wil toezicht op beurzen, February 24th 2005.
56
See FT, UK City watchdog warns over foreign takeover of London Stock Exchange, 5 February 2005
57
M. Vander Stichele, Is de financiële crisis voorbij?, SOMO (Amsterdam),1999, p. 20-21.
58
Mark Houben & Menno Tamminga, “Leaseaffaire breekt alle records”, in NRC Handelsblad, 11
February 2005; NRC Handelsblad, “Leaseschadefonds int 425 mln extra”, 11 February 2005
59
F. Gimbel, Investors ignore risky practices, in FTfm, 1 September 2003, p. 1.
60
Randall Dodd, Derivatives Markets: Sources of Vulnerability in U.S. Financial Markets, Derivatives
Study Center, at www.financialpolicy.org
61
Randall Dodd, Derivatives Markets: Sources of Vulnerability in U.S. Financial Markets, Derivatives
Study Center, at www.financialpolicy.org
62
Based on information from the Derivatives Study Center, (www.financial policy.org; Barry Eichengreen,
“Governing Global Financial Markets: International Responses to the Hedge-Fund Problem,” in Miles
Kahler and David A. Lake Governance in a global economy, Princeton University Press, 2003
63
Kyle L Brandon, The state of hedge funds:2004, SIA research reports, 20 September 2004, at
www.sia.com
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 50
64
Kyle L Brandon, The state of hedge funds:2004, SIA research reports, 20 September 2004, at
www.sia.com
65
J. Chaffin, SEC report proposes hedge fund registration, in FT, 30 September 2003.
66
P. Davis, UK Charity funds gain by sticking to equities, in FTfm, 19 January 2004, p. 2
67
Under the regulatory yoke, FTfm, 19 January 2004, p. 28
68
Christel Witteveen, Groot geheim. Het beleggingsbeleid van pensioenfondsen, in People, Planet Profit,
Volume 3, no 2, Winter 2004/5
69
D. Brewster, Market timing double blow for Alliance, in FT, 19 December 2003; D. Brewster, Janus puts
executive on indefinite leave, in FT, 6 April 2004.
70
D. Brewster, Prudential oust 12 brokers over watchdog probe, in FT, 2 October 2003; E. Kelleher, SEC
set to charge MFS, in FT, 9 December 2003; D. Brewster, Market timing double blow for Alliance, in
FT, 19 December 2003; Beleggingsfondsen in de VS sjoemelen op grote schaal, in Het Financieele
Dagblad, 5 November 2003; A. Michaels, D. Wells, Morgan Stanley fined over mutual funds, in FT, 17
September 2003.
71
D. Wells, Bank falls foul of family favourites, in FT, 5 March 2004.
72
The Committee of European Security Regulators, Investigations of mis-practices in the European
Investment Fund Industry. Report of the investigations by CESR’ members, November 2004, at
www.cesr-eu.org
73
G. Dekker, Dat geld(t) voor ontwikkeling - geld voor duurzaamheid, NCDO (Kroniek voor duurzaam
Nederland (8)), [2001], 13-15.
74
Financial Stability Forum, Statement by Roger W. Ferguson, JR., Chairman of the Financial Stability
Forum, International Monetary and Financial Meeting, 21 September 2003
75
see J. Kinuthia, Trading in Healthcare Services in Kenya, are we prepared? Case study on the
implications of committing healthcare services in Kenya under GATS , Consumer Information Network
(Kenya), November 2002; see www.somo.nl
76
Economist, Just how rotten? The insurance scandal,
77
FT, PwC to give adverse opinion on AIG, 3 May 2005 ; FT, AIG's share price is re-examined, 9 May
2005
78
For more information on the controversies of ECA’s, see Both Ends, Export Credit DEBT; briefing
paper. How ECA’s turn private risks of corporations into debt for developing countries, at
www.bothends.org; Trouw, Banken slepen Financiën voor rechter, Ontwikkeling weggecijferd, July 12
th
2004, at www.trouw.nl. For more info, see also: www.eca-watch.org
79
Standard & Poor’s, Concentration Risks Remain High at European Banks, October 22th 2004
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 51
Chapter 2
Insights in the financial industry:
trends and strategies
Introduction
The financial services described in the first chapter are provided by the private financial
industry. Most of these financial firms do not provide the whole range of financial services.
Although all banks and insurance companies have started to operate at national levels,
some of them are now important players at the international level. Some financial
conglomerates are established in many different countries, including developing countries.
Others are the main providers, worldwide, of certain financial services and dominate the
international market.
This chapter identifies the major international financial corporations, explains the big
players’ strategies and analyses trends in the international financial services markets.
The analysis intends to provide an insight into the problems these international players
and international financial services markets cause to civil societies and economies,
particularly in developing countries.
2.1 Performance of the financial services industry
a. The financial industry has changed dramatically in the past ten years. Important
shake-ups have affected its performance.
Bigger, faster, more
Bigger financial corporations were formed by mergers and acquisitions or
takeovers (either friendly or hostile).
Faster transactions were created via new technologies and the internet.
More diverse financial products were sold by one single financial conglomerate,
such as insurance and securities.
The changing functioning of financial firms was given a boost with the ratification of the
Gramm-Leach-Billey Act (1999) in the US. The act allowed US banks to expand beyond
their traditional roles of collecting deposits and writing loans
1
and become "allfinanz"
firms as was already possible in European and Asian countries. The liberalisation of
financial services, which allows foreign financial firms to provide services through
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 52
ownership of domestic banks or through trans-border transactions, has also contributed to
the changes (see chapter 6).
Downfall … and upturn in profits
In 2001 and 2002, banks suffered heavy losses from the economic slowdown. Many
financial products, including mortgages and trading in securities, were linked to the value
of the stock market. The economic downturn forced banks to write off billions of dollars in
exposure due to the many real estate and commercial loans that went sour. Bankruptcies
at corporate giants like Enron and WorldCom have also burned large banks such as J.P.
Morgan Chase.
As people put more of their cash into mutual funds and securities rather than deposit
accounts, all banks became increasingly dependent on fee-based services such as
securities trading. In 2001, the top 1000 banks in the world recorded a fall in profits of
30%. However, profits began to recover in 2002 due to the strength of the US banks. Their
growth in 2002 was due to increasing commercial and retail banking services, and
underwriting or trading in governmental and corporate bonds
2
at a time that corporate
lending, investment banking for big business and trading in securities had dropped.
The total pre-tax profit of the top 1000 banks in 2002 was US$ 252.4 bn, which was more
than the GDP of countries like Belgium, Sweden and Austria, and most developing
countries, in the same year. Peak profits had been recorded in 2000 when total
aggregated return on capital reached $ 317 bn.
3
The 210 US banks accounted for 49% of
the profits of the top 1000 banks in the world. In contrast, the 83 German banks only
contributed to 1.1% of the profits of the top 1000 banks. The top 300 European banks had
pre-tax profits $120.2 bn by July 2003.
4
Top banks recorded high profits again in 2003 and the first quarter of 2004, amongst
others from tight expense control, strong retail and commercial banking, diversification of
services and renewed activities in securities.
5
Serious financial problems at European insurance companies
The insurance industry was in very bad shape by 2002, especially in Europe where
billions of Euros were lost (see insurance companies at the end of the table below about
World ranking of the largest financial corporations). It led to a German life insurance
company filing for bankruptcy (Mannheimer Leben) in 2003, which had not happened for
50 years.
6
European insurance companies suffered heavy losses from 2001 onwards for a
combination of reasons, namely:
The steep fall in the value of equities in which insurers had invested heavily
(unlike their US counterparts) as capital reserve.
The terrorist attacks starting on 11th September 2001 which led to heavy
insurance claims.
The impact of SARS.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 53
Because of regulatory requirements, the insurers had to sell off their holdings but the
uncertainty around the amounts to be sold and the timing of the sales precipitated price
declines, further destabilising the stock market as a whole. The result was trading equities
out of the need for capital, which is a dangerous phenomenon, one that also led to stock
market drops in 1987 and 1998.
7
The serious need for capital by insurance companies was an abrupt change from the past
situation where the insurance industry was a provider of capital.
In order to alleviate shrinking capital reserves, and raise capital, the insurance industry
responded in a variety of ways:
Raising premiums: increasing their prices for insurance coverage.
Restricting insurance cover: increasingly, more and more scenarios and/or
events are not covered by insurance contracts leaving people and companies
with little or no coverage for some risks. The result is that more often individuals
and companies have to pay themselves the cost of certain events. Clients have
found that risks that were once covered by their policy, now are not, and are
becoming dissatisfied.
Issuing stocks and bonds: insurance companies are raising cash by issuing
equities and bonds. In 2003 insurance bonds were worth more than $ 9.6 bn,
8
but
given the current unstable state of the whole industry, it is unlikely more bonds
will raise much.
Pension insurance gap: pension funds that invested in shares saw the value of
their assets change with the ups and downs of the stock market. 2003 saw signs
of economic recovery from the three years of losses previously, however a gap to
cover all future obligations still exists. The global pension fund gap is between
$1,500 bn to $2,000 bn, so on average, pension funds are still underfunded by as
much as 20% and it could take up to 5 years to close the gap. Another "problem"
for pensions is that people are living longer and therefore draw on their pensions
for more years than previously.
9
Shift in business: the insurance industry has shifted business from life insurance
coverage to annuity products. This fundamentally changes the way life insurance
firms do business, as they concentrate on managing the investment risk, rather
than on the mortality risk of an individual. As a result, insurance firms now
compete more directly with financial services firms.
10
Technology changes that move the sector
Technology has had a major impact on changes in the financial industry in the way it sells
products and in the way it operates, both internally and externally. Technology is vital to
the workings of the many complex products (e.g. derivatives) and transactions (security
trading).
Electronic transactions have more than doubled since 1995 and they are expected to
double again by 2005. Internet banking is becoming more and prominent, as both large
and small banks offer web sites where customers can access accounts and buy financial
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 54
products. Several web-only banks have also popped up, including NetBank, Egg plc. and
ING Direct.
11
However there are still some technical problems to be solved including:
safety and security in e-finance on the internet,
coordinating different software between different divisions,
coordinating the technological integration after a merger or acquisition.
2.2 Structure of the financial industry: rankings of top
financial firms
The following rankings and tables provide an overview of those dominant companies in
the financial services sector worldwide. They are the financial conglomerates that buy, sell
and trade the most financial products described in chapter 1 above. They are also the
strongest proponents of deregulating of the financial markets and liberalisation financial
services (see chapter 6).
2.2.1 World rankings
The ranking of the financial industry is complicated by the various ways to work out
rankings and the constant restructuring of the industry. The table of the ranking of the
largest financial firms in Euros does for instance not include the takeover of FleetBoston
by Bank of America (nr. 2 in the world, ranked by net profit) in late 2003. These merged
US financial firms will however not take over Citigroup as world number one. The
combination of J.P. Morgan Chase who decided to buy Bank One for $58 billion in
January 2004 is likely to become the second-largest bank in the US.
Table: Banks ranked by market capitalisation (US$ bn, 2005)
Rank Company Home country Market value (US$
bn)
1 Citigroup US 255.3
2 HSBC UK 178
3 Bank of America US 117.5
4 Wells Fargo US 97.5
5 Royal Bank of Scotland UK 90.2
6 UBS Switzerland 85
7 JP Morgan Chase US 81.4
8 Wachovia US 62.3
9 Barclays UK 61.3
10 BNP Paribas France 59.3
Source: Forbes 2000 list, April 2005, at: www.forbes.com
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 55
Table: Banks ranked by assets, 2005
Rank Company Home country Assets (US$ bn)
1 Citigroup US 1,264.03
2 Mizuho Financial Japan 1,115.90
3 Sumitomo Mitsui Financial Japan 868.42
4 Mitsubishi Tokyo Financial Japan 827.48
5 J.P. Morgan Chase US 792.70
6 Barclays UK 791.54
7 HSBC Holdings UK 757.60
8 BNP Paribas France 745.09
9 Bank of America US 736.45
10 HVB Germany 705.36
Source: Forbes 2000 list, May 2005, at: www.forbes.com
2.2.2 A short analysis of the world top financial
conglomerates
Citigroup, the first truly global allfinanz conglomerate, dominates each ranking.
Citigroup’s large size was created in 1998, in anticipation of more bank deregulation in
1999, when Travelers Group insurance bought retail and commercial bank Citicorp and
created Citigroup. It is now active in more than 100 countries in all kind of financial
activities.
Bank of America is less internationally oriented than Citigroup with a presence in 30
countries (incl. the US, 5 in Latin America and 7 in Asia)
12
. It has the most extensive
network of bank branches in the US.
All of the top financial firms are the result from a series of mergers and acquisitions, trying
to use the network of one firm to reach clients for the other firm (e.g. J.P. Morgan Chase
was formed by bank Chase Manhattan buying investment bank J.P. Morgan in 2001).
Japanese banks are still highly ranked according to assets. Large mergers took place
last decade such as Dai-Ichi Kangyo Bank, Fuji Bank, and Industrial Bank of Japan which
merged to form Mizuho in 2001. In 2004, Mitsubishi Tokyo Financial Group and UFJ
Holdings, struck an agreement to merge. This merger will lead to the world's biggest bank
in terms of assets. . However, experts state that Japanese banks are the weakest,
together with the German banks, of the developed countries. This is the case since the
Japanese banking system has serious non performing loans problems, and have suffered
heavy losses in recent years ($39 bn in 2002).
13
In the Forbes ranking (that also takes
sales, profits and market value into account) the first Japanese bank on the list is
Sumitomo Mitsui Financial at rank 396. In 2004, the position of Japanese banks slightly
improved; instead of losses like in the years prior the 113 Japanese banks in the Forbes
1000 list managed to make net profits aggregating to $14,9 bn.
14
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 56
New comers in the future might be Chinese banks as some are currently being (partly)
privatised and bought up by foreign financial firms. The International Commercial Bank of
China (ICBC) is the largest commercial bank in China and would rank in the top ten
commercial banks worldwide based on assets.
15
In terms of quality, the Hongkong and Shanghai Banking Corporation (HSBC) won the
Global 2004 Bank of the Year Banker Award and the 2004 Global Bank award. Citigroup
wan different other awards such as the Global Finance Magazine's awards for Best Global
Corporate Bank and Best Global Exchange Finance Bank.
Many of the above mentioned financial firms are also high in ranking of the world’s biggest
companies in all sectors. Again, Citigroup ranked first as the world’s largest multinational
measured by a composite of sales, profits, assets and market value in March 2004.
Twelve (60%) of the 20 biggest companies in the world were financial firms. Of the 100
biggest global companies, 41% (41) were financial firms with a total net profit of US$
166.9 bn.
16
Table: Ranking of all financial firms according to Forbes 2000 list of the world
largest companies (US$ bn, March 2004)
World
company
ranking
Name Country Category Sales
($bn)
Profits
($bn)
Assets
($bn)
Market
value
($bn)
1 Citigroup United
States
Banking 94.71 17.85 1,264.03 255.30
3 American
Intl Group
United
States
Insurance 76.66 6.46 647.66 194.87
6 Bank of
America
United
States
Banking 49.01 10.81 736.45 117.55
7 HSBC
Group
United
Kingdom
Banking 44.33 6.66 757.60 177.96
9 Fannie Mae United
States
Diversified
financials
53.13 6.48 1,019.17 76.84
11 UBS Switzerland Diversified
financials
48.95 5.15 853.23 85.07
12 ING Group Netherlands Diversified
financials
94.72 4.73 752.49 54.59
14 Berkshire
Hathaway
United
States
Insurance 56.22 6.95 172.24 141.14
15 JP Morgan
Chase
United
States
Banking 44.39 4.47 792.70 81.94
18 BNP
Paribas
France Banking 47.74 4.73 745.09 59.29
19 Royal Bank
of Scotland
United
Kingdom
Banking 35.65 4.95 663.45 90.21
20 Freddie
Mac
United
States
Diversified
financials
46.26 10.09 752.25 44.25
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 57
25 Wells Fargo United
States
Banking 31.80 6.20 387.80 97.53
27 Barclays United
Kingdom
Banking 33.69 4.90 791.54 61.33
28 Morgan
Stanley
United
States
Diversified
financials
33.00 3.64 580.63 64.81
34 Deutsche
Bank Group
Germany Diversified
financials
58.85 1.53 792.49 50.23
36 HBOS United
Kingdom
Banking 32.68 3.09 571.76 52.87
39 Banco
Santander
Central
Spain Banking 28.70 3.28 442.24 56.78
40 Merrill
Lynch
United
States
Diversified
financials
26.64 3.47 485.77 57.52
41 Wachovia United
States
Banking 24.47 4.25 400.87 62.35
47 Lloyds TSB
Group
United
Kingdom
Banking 24.48 2.87 406.99 48.11
48 ABN-Amro
Holding
Netherlands Banking 23.64 3.98 704.95 39.29
50 American
Express
United
States
Diversified
financials
24.17 3.00 175.00 68.89
52 Bank One United
States
Banking 21.04 3.40 290.01 58.38
53 AXA Group France Insurance 90.10 1.00 456.13 41.39
54 Société
Générale
Group
France Banking 35.52 1.61 526.54 40.61
56 Goldman
Sachs
Group
United
States
Diversified
financials
22.84 2.54 394.14 50.12
57 BBVA-
Banco
Bilbao
Vizcaya
Spain Banking 24.10 2.81 288.80 44.67
59 MetLife United
States
Insurance 35.79 2.24 326.84 26.34
62 Allstate United
States
Insurance 32.15 2.73 134.14 32.90
67 Washington
Mutual
United
States
Banking 18.01 3.88 275.18 39.69
68 Crédit
Agricole
France Banking 31.77 1.12 531.01 38.80
73 Munich Re Germany Insurance 45.85 1.14 191.33 26.63
77 US United Banking 14.57 3.73 189.29 52.88
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 58
Bancorp States
79 Royal Bank
of Canada
Canada Banking 18.82 2.28 305.01 31.82
86 Natl
Australia
Bank
Australia Banking 15.34 2.69 269.94 36.51
90 FleetBoston
Finl
United
States
Banking 14.22 2.13 196.40 47.19
92 UniCredito
Italiano
Italy Banking 16.53 1.89 223.60 33.53
96 Fortis Netherlands Diversified
financials
52.51 0.56 507.98 30.19
98 Aegon
Insurance
Group
Netherlands Insurance 17.75 1.63 266.59 23.49
99 Dexia Belgium Banking 19.62 1.36 368.37 21.64
Source: Forbes 2000 list, March 2004, at www.forbes.com: measuring based on a composite of
sales, profits, assets and market value; including some figures of net profits in 2003.
Critical issues
Citigroup the top player
Citigroup's domination of the financial sector is significant. Citigroup's net profits
in 2002 and 2003 exceeded those of the second bank ranked by net profit, Bank
of America, by more than 60%. The sales of Citigroup are the same as those of
ING Group but Citigroup makes almost 4 times more net profit. This puts pressure
on the other financial firms to try and achieve ever-higher profits while continually
expanding. Citigroup might become the model and benchmark for others.
American and European financial firms dominate
The top 100 financial firms are completely dominated by those from the US and
Europe. It raises the question how much capacity banks from developing
countries might have to compete internationally against these large players.
Financial groups dominate world ranking
The fact that more than 40% of the 100 top world companies are financial firms
indicates how their current strategies are successful in making profit. The net
profit of all these 41 top financial firms is just less than the GDP of Denmark and
more than the GDP of for instance Hong Kong China, Greece, Finland, Thailand
and most developing countries.
17
The financial sector is more than other sectors
able to raise in the ranks of top world multinationals. In a world where stock
markets and share values are globalised, this puts constant pressure on
companies to increase profits.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 59
2.2.3 Regional rankings
Top European banks
The major European players at the top financial markets in Europe are HSBC (UK),
France’s Crédit Agricole, Royal Bank of Scotland and Deutsche Bank. ING Group (NL),
UBS (Switzerland) and HBOS (UK) are also top players in Europe.
18
Increasing presence of Western banks in Africa, Asia and Latin America
In Latin America, Africa and Asia, analysis shows that the top players are still banks from
their own region. But more and more Western players are taking a share of the market.
For instance, foreign financial firms that have become important in many Latin American
countries are Spanish Banco Santander, Banco Bilbao de Vizcaya (BBV) and Banco
Central Hispanoamericano, as well as HSBC (UK), Bank Boston (US), Sudameris (FR)
and ABN Amro (NL).
19
Citigroup became the dominant player in Mexico.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 60
A small company profile of a large financial conglomerate: Citigroup
20
Citigroup has dominated the financial services world for the last five years,
21
with net profits at
$ 17 bn in 2003. Citigroup's profits rose 17% compared with the year 2002.
22
Citigroup's net
profit in 2002, if compared with countries’ GDP, would rank 76 in 2002 with Serbia and
Montenegro at 75 and Belarus, El Salvador, Panama and Kenya among the countries
following.
Operational in more than 100 countries, well ahead of all others, it has the greatest distribution
capacity in the world. The group brings together banking, insurance and investments in one
corporation to offer a diversity of financial products.
Ambitions?
Citigroup was the first financial corporation to have establishments in all EU countries for
corporate banking activities even though it was American.
23
As explained to the Financial
Times, Citigroup has the ambition “to reach top ranking for every product it sells and in every
category it services in all regions”. Citigroup wants to increase revenue across the globe by an
additional $ 130 bn a year from potential fees for its corporate and investment bank business.
Citigroup’s CEO recently said the future strategy would be to make smaller rather than larger
acquisitions, with a focus on ‘fill-in’ deals, which are small by his company’s standards.
Previous ‘fill-in’ deals include extending Citigroup's consumer banking reach, or for example
the purchase of Poland's Bank Handlowy and Mexico's Banamex. It is still up in the air as to
whether the Bank of America and FleetBoston merger will challenge Citigroup to take up larger-
scale acquisitions in the financial retail sector.
24
Size and outreach
To get to a grasp of the financial strength of the Citigroup, here are some figures: At the end of
2003, Citigroup’s assets totalled $ 1.264 trillion,
25
the company has 275,000 employees,
26
there are 200 million customer accounts in more than 100 countries, the company is the largest
provider of credit cards in North America, and it has more than 3000 branches worldwide, not
counting the 766 branches in the US.
Domination? Examples
Biggest global underwriter of bonds in 2003; arranged $ 41.9 bn in bond sales in 2003 fourth
quarter alone.
The top company in global equity offerings at the end of 2003; arranged $10.6 bn in initial
public offering of shares (IPO) deals.
27
Number 1 derivatives dealer.
28
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 61
Ranking of banks in Asia is dominated by four Chinese banks, followed by the Hongkong
and Shanghai Banking Corporations (HSBC, headquartered in the UK) and National
Australia Bank.
29
The positions in the 2003 top 100 Sub-Saharan banks are occupied by the "big five" South
African banks: Standard Bank Group, FirstRand Banking Group, ABSA Group, Nedcor,
and Investee. The major shareholder (14%) of Standard Bank is the Old Mutual Group
30
with activities in South Africa, the US, the UK and some other countries. Standard Bank is
the only South African bank with significant presence in the rest of the continent. Other
major Sub-Saharan African players are based Mauritius or Zimbabwe. Foreign banks with
a significant presence in Sub-Saharan Africa are Barclays (UK), Fortis (B-NL, via Banque
Belgolaise), BNP (F) and Société Générale (F).
31
2.2.4 Sectoral ranking
Project lending mostly done through European banks
32
, as opposed to project
bonds
Most project lending comes from European banks which financed US$ 70 bn in global
projects in 2003. Forty one billion US$ was allocated to European projects, mostly for
infrastructure in the energy sector. American banks are not very active in for project loans
because the profit margins are too small.
Table: World top financiers of project financing through credit
Rank Bank Country
1 Crédit Agricole/Crédit Lyonnais F
2 Royal Bank of Scotland UK
3 BNP Paribas F
5 Société Générale F
… Barclays UK
… WestLB D
Source: Het Financieele Dagblad, Kredietverlening aan grote projecten klimt uit het dal, 23 January
2004; based on data from Thomson Financial
Increasingly, projects are financed through bonds. In Europe, bond project financing grew
to $9 bn from $2 bn in one year. American banks beat the ranking for project financing
through bonds. In 2004, the best project-financing award from The Banker went to
Citigroup
33
.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 62
Table: World top project financiers through bonds in 2003
Ranking Bank Country
1 Citigroup US
2 Credit Suisse First Boston (CSFB) Switzerland
3 Lehman Brothers US
4 …
5 ABN Amro NL
Source: Het Financieele Dagblad, Kredietverlening aan grote projecten klimt uit het dal, 23 January
2003; based on data from Thompson Financial
Governmental institutions seeking project-financing advice are turning to accountants
rather than banks to cut costs. The top global advisors for project financing are:
Table: World top global advisors for project financing
Ranking Advisor
1 Ernst & Young
2 PriceWaterhouseCoopers
3 …
4 KPMG
5 ABN Amro
Source: Het Financieele Dagblad, Kredietverlening aan grote projecten klimt uit het dal, 23 January
2003; based on data from Thompson Financial
American investment banks dominate the global market
The top global players in investment banking are American financial firms, which include
Citigroup Global Markets (formerly Salomon Smith Barney), J.P. Morgan Chase, Goldman
Sachs and Morgan Stanley. The 2004 Banker Award for both the best Bond House and
best Equity House of the Year went to Morgan Stanley. Goldman Sachs received the 2004
Banker Award for the best activities in supporting and financing mergers and acquisitions
(M&A House of the Year).
The high fees make investment banking a very attractive business but many global
players from other countries have difficulties in competing with these US banks in their
investment bank activities. Since 1995, Japanese investment banks have been largely
driven out of all capital market services.
34
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 63
Table: Investment banking companies ranked by sales
Rank Company Country
1 Citigroup Global Markets US
2 J.P. Morgan Chase US
3 Goldman Sachs US
4 Morgan Stanley US
5 Merrill Lynch US
6 Credit Suisse First Boston Zwi
7 Lehman Brothers US
8 Bank of America Securities US
9 UBS Investment Bank Zwi
10 Deutsche Bank D
Source: Hoover’s Industry snapshots, Investment banking, [15 January 2004].
2.2.5 Global concentration in some financial services
sectors
Still many domestic financial firms compete with the large world players for various
products. However, in some financial services sectors, a few big players dominate the
business and prevent other financial firms to compete or enter the market. Such
'concentrated' or oligopolistic sectors include:
Credit derivatives market: Trading in the credit derivatives market is
concentrated among a small number of financial firms
35
. Especially the
investment bank arms of commercial banks such as Citibank and Morgan
Guarantee Trust do a large part of the intermediation between buyers and sellers
of credit risk protection. Most of the trade is done in London and New York.
Commercial banks are the main issuers of credit risk derivatives ( and thus net
buyers of credit risk protection), while commercial banks,insurance companies,
hedge funds and pension funds account for most of sales of credit risk
derivatives.
Rating agencies: Three rating agencies that analyze creditworthiness are each
most used and respected around the world.: Standard and Poor's corporation
('S&P'), Moody's Investors Service and Fitch Ratings. All of them are US based.
The top 10 property and casualty insurance companies, including State
Farm, Aviva, American International Group, and Zurich Financial Services
account for almost half of all premiums written. A decreasing number of local
firms are left to fight for the remaining scraps of market share.
European and American investment banks in South-East Asia have established a
oligopoly in two services in the regional capital markets:
underwriting in the primary market and distribution of new share issues
(investment banking),
trading in securities and bonds and consulting in the secondary market,
i.e. the market that deals with equities trade after the original issuance.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 64
From 1998-2001, American and European investment banks held 74% of
financing through capital markets, i.e. from shares, in five South East Asian
countries.
Concentration also tends to take place at the national level. Countries that have been
deregulating tend to have more and more mergers and acquisitions resulting in
consolidation and foreign take-overs. Financial services then tend to concentrate in a few
companies, as is the case in Hong Kong, Belgium and the Netherlands.
2.3 Trends and strategies: financial service companies
Information technology, deregulation and liberalisation have dramatically affected the
financial services industry contributing to two important trends namely, consolidation and
increased competition at both the national and international levels. These two trends
impact societies and economies, especially in relation to poverty eradication.
2.3.1 Consolidation
36
‘Consolidation of financial services’ means that financial services worldwide are
increasingly concentrated in the hands of a few corporations as described in the structure
of the financial industry above. Consolidation is seen as the single most important factor
transforming the financial services industry since almost a decade. Many experts predict
that consolidation will continue and within 5 to 10 years, there will be only five to ten top
financial conglomerates in the world.
In search of more profit opportunities, most consolidated financial firms did not so much
expand organically as grow through mergers and acquisitions or takeovers that were
either friendly or hostile. Such consolidation took place at national level and more
importantly at international levels with ‘cross-border consolidation’ by trading and investing
in financial services in many countries around the world. Also, many financial services
categories such as retail banking and insurance, were increasingly being brought under
one corporate roof which is called ‘cross-category consolidation.’
The strategies behind consolidation are:
Increasing the number of customers and beating competitors by selling various
financial products through one distribution channel (one stop shopping);
diversifying products and customers to avoid risk (like putting too many eggs in
one basket, if the basket breaks, the whole business might be lost) and to finance
a loss-making part of the business with the profits of another part of the business
(cross-subsidization);
maintaining a large capital base as buffer to absorb losses and absorb the
growing cost of technology;
increasing the quality of service and products to gain the trust of the customers;
increasing profitability not to loose out against competitors.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 65
The causes of consolidation are also political:
Governments (some under pressure from the IMF and World Bank) have opened
up their financial services for trade and investment by foreign competitors. Once
foreign financial firms take a share of the domestic market, domestic companies
try to expand their market by going abroad.
Governments have removed restrictions preventing different kinds of financial
services to be part of one financial corporation. In the US, the Glass-Steagall Act
(of the 1930s) and the Bank Holding Company Act (1956) were withdrawn.
State banks in developing countries are being privatized and state aid to financial
institutions is stopped e.g. in the EU due to rules of the European Single Market.
The introduction of a single currency such as the Euro has stimulated cross-
border activities and consolidation.
The new capItal accord agreed upon by Western central bankers regarding
capital reserves to cover loans ("Basel II": see chapter 5) wIll prIorItIze large
banks. ThIs Is the case because large banks will be able to use an internal risk
management system, and have to putless capital aside than smaller banks
without such systems. Smaller banks will have to use a standard approach that
requires to put aside much more capital than the larger banks. Smaller reserves
make the larger banks more profitable.
Liberalisation in trade and investment in financial services often leads to national banks
being unable to compete with internationally operating banks. As a result of consolidation,
the numbers of medium-sized banks and large national financial firms (as opposed to
mega conglomerates) can decrease even if they are the largest in a country. In most
OECD countries, consolidation has worked against existing medium-sized financial
companies through merging or being acquired by larger banks. In countries like the
Netherlands and Belgium consolidation has lead to a financial industry market dominated
by 5 financial groups.
Where governmental rules have not allowed consolidation however, foreign takeovers
have not taken place, as is the case in Italy or Germany.
37
Consolidation continues
Citigroup once declared it wanted one billion customers in ten years
38
and now has 200
million customer accounts worldwide, which is the clearest example of cross-category and
cross-border consolidation. The merger of Bank of America (US) and FleetBoston (US) at
the end of 2003 is another example of increasing competition and pushing smaller firms
out of the market. It was also seen as the start of a new wave of consolidation.
The more mergers and acquisitions, the more consolidation intensifies. When J.P. Morgan
Chase (US) decided to buy Bank One (US) in January 2004 to become the second largest
US bank after Citigroup, analysts wrote: "Citigroup was for the last two or three years
head and shoulders above the competition …We think Citigroup will now be prodded to do
a deal", while Citigroup had indicated it had only plans to make smaller strategic
purchases.
39
Consolidation across boarders is however often complicated by national
legislation, different currencies and corporate cultures.
40
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 66
One of the reasons why foreign banks are allowed to take over domestic ones is because
the foreigners promise to inject capital, better allocate resources and supply solid
management. This is especially attractive to developing countries, particularly during or
after a financial crisis.
Experts expect that, in the future, small financial firms with a clear local or regional focus
or high specialization might still make enough profit to keep their independence from
mega conglomerates and continue to exist.
The new battlefields
Consolidation will continue because new markets are opening.
China, perhaps the most interesting and the most lucrative market, is opening up after
Western financial firms successfully lobbied very extensively during China's accession
negotiations to the World Trade Organisation (WTO). Many top financial firms have
already acquired parts of those Chinese banking divisions as allowed under the
agreement.
41
Foreign banks, such as ABN Amro, tend to target rich clients.
42
Many
Western financial firms are involved in the restructuring of the Chinese banking sector.
Citigroup has bought a big share of many of the non performing loans (NPL) of the four
big Chinese state-owned banks. Morgan Stanley and Goldman Sachs have arranged joint
ventures with Chinese banks
43
. Obviously, they all hope to get a market share in this
huge, fast-growing economy.
Consolidating through mergers and acquisitions is rampant in Central and Eastern
Europe where regional and European banks are trying to extend their market share. The
biggest players are Austrian and Italian.44 Austrian banks have a clear strategy of making
acquisitions in Central and Eastern Europe. The Bank Austria Creditanstalt45 is protected
against political upheaval through the World Bank’s Multilateral Investment Guarantee
Agency (MIGA) Political risk insurance might be necessary when taking over privatised
banks. Privatisation of state banks, including peoples’ banks at the post office which have
always intended to give access to everyone, is taking place throughout the region. Some
bigger banks from Central and Eastern Europe are also taking over smaller ones and
those in neighbouring countries.
Only 25-30% of Russian adults have bank accounts leaving the rest of the country
stuffing money in their mattresses.
46
It remains to be seen how far Western financial firms
will adapt to Russian circumstances and can be trusted by Russians. Before the 1998
Russian financial crisis, foreign banks promised much but did deliver little.
When participating in national and regional consolidation, financial conglomerates
increasingly focus on core business in core regions. They are continuously selling off
inefficient or unprofitable units and buying new ones in their core business or region. And
where financial conglomerates cannot acquire or takeover and win a sufficient market
share, they tend to sell units off because each firm strives to achieve the top spot in its
core business and its core regions.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 67
Critical Issues
Big is not always better
Large, diversified financial companies operating in many countries are more
difficult to manage and control. Different financial services have different risks
(banking risks are not the same as risks in insurance) and new management
might lack the necessary expertise.
Mergers and acquisitions can fail
Merging different corporate cultures is not always smooth or successful.
Research shows that in general more than 50% of corporate mergers and
acquisitions fail.
Risky business
It is risky creating financial firms that are difficult to monitor and “too big to fail.”
Bankruptcy of such conglomerates is often prevented even if the banks are
mismanaged. To prevent shock waves throughout the economy when the
conglomerate falls into trouble, governments become the “insurer of last resort” or
hold deposit insurance schemes. This means tax payers pay the bill and losses
are ‘socialized’, while on the other hand, profits are privatised.
Banks get political power
Generally, the concentration of economic power in a few consolidated banks
increases their political power. Governments are also dependent on financial
conglomerates for loans and bond underwriting. The political power of the
financial industry is evident from the lobby against debt restructuring (see chapter
5) and in favour of international liberalisation of financial services in the GATS
(see chapter 6).
Conflicts of interest
While integrated banking brings benefits like reduced costs, product diversity and
cross-subsidisation of different activities within the financial company, it also
brings conflict of interest between the different services for which some
investment banks have been indicted (see chapter 1: Scandals at financial firms).
Complicated regulation
Cross-border and cross-category consolidation complicates the work of financial
regulators and supervisors at national and international levels. The growing
number of financial conglomerates, particularly those active in several countries
require proper handling (both preventive and corrective) by the regulatory and
supervisory financial institutions as well as effective coordination and cooperation
between supervisors within one country, and between the national supervisors in
different countries. At the moment, an ideal regulatory environment, which
functions at the various levels, does not exist (see chapter 5).
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 68
Little evidence of knowledge transfer
Contrary to what is mostly argued
47
, experience shows that a foreign takeover of
a financial service provider does not always lead to a transfer of knowledge and
skills to local banks. Most foreign banks tend to attract the more experienced
personnel from domestic banks and other foreign banks in the host country than
they lose personnel to those local banks. China has experienced the brain drain
on the domestic banks when foreign ones enter the market (see chapter 6).
Will prices, eventually, increase?
High concentration of economic power leaves governments and customers little
choice, which might lead to an unnecessary price increase. During the first phase
of competition prices should fall, but later, when only a few players dominate the
sector, tacit price-fixing will drive prices back up. This is not a hypothetical
scenario. Secret price-fixing has occurred repeatedly, even if it only seldom
comes to light, as it did recently in Germany. Authorities reported that the
insurance companies Allianz, Gerling, HDI, Axa, Aachener, Münchener, Gothaer
and Victoria, illegally price-fixed as their industrial customers found out. Allianz
board member Hagemann has now admitted: “There were informal contact
groups.”
48
Encouraging risky lending
Consolidation combined with strong competition among financial services leads to
difficult dilemmas. It may enhance the efficiency and lending of the banks and
lower prices for consumers and the whole economy. But more competition also
tempts banks to engage in riskier lending (as was the case in the Asian financial
crisis), and other practices that destabilise the banking industry, which has very
costly repercussions for the whole economy.
Problems in implementing competition policy
Increasing consolidation also leaves difficult dilemmas for financial supervisors
and the implementation of competition policy. In small countries, competition
policy officers might block mergers and acquisitions to prevent domination in the
domestic financial market. At the same time, allowing a domestic financial firm to
become dominant might be the only way to avoid takeovers by foreign financial
firms. Sweden and the Netherlands have allowed for the creation of a few
"national champions". The Dutch banks have subsequently become important
international players.
Top ranked financial firms active in financial sectors where only a few operate
might engage in anti-competitive activities such as price fixing (directly or
indirectly by following the others’ price changes), and anti-competitive cross-
subsidisation. However, at the global level, there is no broad competition authority
that deals properly with global anti-competitive practices. Intervention from the
national country might not be sufficient to tackle the problems.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 69
Only out for profit
Consolidation takes place where profit will be made. Foreign financial firms
consolidate in developing countries to try and win a significant part of the market
share and earn profits. They will not invest or waste time in a country where there
are no profits to be made.
High technology costs
Merging technologies of two financial firms after takeovers and within
consolidation phases is expensive and complicated. The various parts of the
financial firm need to match and integrate systems with other solutions used
across the bank. Coping with the many changes the financial industry faces
49
is a
huge challenge. At the same time, large middle market banks have started
offering improved global payment services as increasingly small and medium
sized industries find business overseas, making the very small business market
underserved.
50
Increasing intra-firm cross-border flows
Transactions and lending around the world, between different parts of the same
company, accounted for a major increase in capital flows during 2003.
51
2.3.2 Competition
Consolidation is the financial industry’s way of dealing with increasing competition.
Governments, regulators and supervisors worldwide try to create and maintain a free
market with many competitors, all in the name of efficiency and lower prices. However, the
financial service sector does not only compete but has been cooperating among
themselves through increase strategic alliances and consolidating.
52
Competition nevertheless remains fierce. The struggle is always for quicker and short term
profit which leads to strategies for more efficiency, lowering costs, expansion of profit
making clients and markets, and "killing" the competitors. The results are, as explained in
chapter 1, as follows:
Cost cutting in services such as closing branches, standardization and
automation of services.
Cost cutting in personnel, which often leads to firing people and sometimes to
lower labour conditions.
Market segmentation: divides up level of services according to the wealth of the
client.
Focus on the richest clients and scale down services to the poor: some
financial firms chose to focus on a few very lucrative services like investment
banking or high technology transaction processing, and offer no lower-margin
traditional banking operations.
Shifting focus: When people started to put more of their cash into mutual funds
and securities rather than deposit accounts, banks of all sizes became more
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 70
dependent on fee-based services. Once the stock market bubble burst, the fee
income from underwriting, acquisition deals and trade in securities had diminished
so much that financial conglomerates turned their attention again to retail banking
and branches.
Cross-selling: offering a diversified packet of financial services to woo and keep
clients.
Cross branding and 'cooptition': Some financial have started to distribute
financial products for their competitors without operating them. For example,
Deutsche Bank is selling the mutual fund products of its rival Fidelity.
53
The larger
and more diversified financial firms are increasingly working together in
cooperative technology ventures for all kind of consumers. For instance, Merill
Lynch and HSBC set up a joint venture for online wealth management service.
54
Outsourcing: to reduce costs, financial firms start to outsource some of their
internal operations, e.g. IT activities, or some of their financial products to other
(financial) firms, often in emerging markets like India
55
.
High costs for technology: In order to offer the most attractive services and
manage the diversified and geographically spread products and operations,
financial firms need to constantly invest in new technology while having to cut
costs in other parts of the firm.
Critical issues
Cherry picking by the foreign financial industry
Rich clients, the best managers and personnel are often cherry picked by foreign
companies. Providing mainstream clients with good service is not a strategic
focus. The rich get the best, which can be particularly pronounced in developing
countries where the poor are excluded from foreign financial services (see
chapter 6 on liberalisation of financial services and GATS). Arguments of
‘efficiency’ on behalf of the authorities and financial industry mostly benefit the
wealthy and the largest corporations
Standardization and automation
Automation in practice can marginalize the poor and seniors who have no access
to internet or computers, or who do not know how to use the machines. Also older
people often fear they will be attacked when taking money on the street. Poor and
young people are often targeted to take out easy, small loans through non-
personal standardised products. When they have problems with repayment,
banks exclude them from other services.
Need for more supervision and regulation
According to experts advising central banks
56
, when competition affects economic
stability, normally the appropriate safeguard is sound prudential regulation or
good corporate governance, rather than limiting competition. Research indicates
that many countries do not have the necessary regulatory and supervisory
systems to address many new problems that arise from the competition.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 71
Moreover, regulators' and supervisors' instruments are mostly assessing the risks
of financial instability, with too little focus at the impact of competition on universal
access, quality of service to the poorer clients and good financing of small and
medium-sized producers.
Moral hazard
Moral hazard is one of the most serious problems at both the national land
international levels.
57
To stay competitive, banks take many risks, as was the
case in South East Asia when competition for new lucrative markets lead Western
banks to increase their highly risky lending in the belief that governments would
intervene if loans defaulted.
States want to protect their citizens against bankruptcy and banking instability,
and prevent people from loosing their savings and being affected by a
devastating economic crisis. At the same time, governmental risk protection
mechanisms -such as deposit insurance systems- tend to encourage banks to
take excessive and dangerous risks. But when losses result from excessive risk
taking, financial firms get "bailed out" at the national level by government safety
nets and at the international level by the IMF. Both are done with money from
taxpayers’, not from the risk takers or the banks that caused the problems.
The balance between protecting innocent citizens against major financial risk and
allowing risky activities of financial companies is the task of national and
international financial regulators and governments. There is however still much
work to be done in developing a financial architecture, which is fair and balanced
(see chapter 5).
Unequal competition in developing countries
When foreign banks enter a new market, their national competitors are often
much less advanced and although increased competition stimulates efficiency,
some domestic banks just cannot compete as is the case for investment banking.
In developing countries, but also in places like Japan, many people simple don’t
trust national banks and put more of their trust, and savings, into foreign banking
services.
The risks of increasing interdependence
The large complex financial conglomerates have become more interdependent,
which means the whole financial system and economy, or systemic risk, is at
stake should one conglomerate face troubles.
Interbank loans, syndicated loans, group underwriting, trading derivatives over the
counter (OTC) with other financial firms, re-insurance, cross branding,
outsourcing, and payment and settlement systems are all examples of increasing
interdependence. Combined with consolidation, financial services become
increasingly more clustered and confusing.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 72
2.3.3 Shareholder value
Many financial firms are listed on the stock market. Their shares are therefore in the
hands of individual investors and mutual funds, both of which could be other financial
firms. Cross ownership /cross shareholdings, in the Netherlands for example, is notorious
and raises questions about real competition and corporate independence.
Share price and share value, regardless of whether the goal is to maintain or increase the
value, is a constant, fundamental concern of the top management of all listed companies,
including those in the financial services sector. When the value of shares falls too low, a
company can be subject to a take over (friendly or hostile) by another bank that buys up
the "cheap" shares. For example, ABN Amro became a world player after consolidation
took place in the Netherlands but feared that low share value put it at risk of being taken
over. In early 2000, the CEO said that the new strategy would focus on shareholder value
and increase profits annually by a minimum of 12.5%! At the height of the economic boom
the bank was indeed able to record a profit of Euro 2.5 bn in 1999, or a 40% increase in
profit compared with the year prior.
58
Even then, thousands of people were laid off. When
the stock market dropped and the economy slowed down at the end of 2001, the CEO had
to adapt his strategy. Nevertheless, his salary was increased.
Shareholder pressure is an important element in the management of (financial) firms.
Shareholders and investors often want to see short-term gains and press for more
efficiency. When cost cutting strategies are announced and people get fired, often at the
behest of shareholder pressure, investors react enthusiastically and share value
increases. This scenario is a disincentive for management to focus on the social or
environmental impacts of the company. Shareholders, therefore, are the most influential
stakeholders in a company.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 73
2.4 Conclusions and critical issues
1. Unequal competition
The top world players in the financial industry are US and European banks, insurance and
'allfinanz' firms. Japanese banks do no longer belong to the top as they were 10 years
ago. It becomes very difficult for the financial industry of other countries and regions to
become part of the world players and 'to enter to world market' in financial services.
Specific sub-sectors such as investment banking and rating agencies are concentrated
world wide in the hands of a few, often US, financial firms. As a result, many domestic
banks cannot compete against these specialized firms when they enter their countries.
While there is still a large choice of commercial banks in some countries (Germany, Italy),
other countries (e.g. the Netherlands, Sweden) have their financial industry concentrated
in the hands of a few.
2. Citigroup is the biggest of all
The biggest world player of the financial industry has for some years been head and
shoulders above the others: Citigroup. Citigroup's net profits in 2002 and 2003 exceeded
those of its nearest contender by more than 60%. Citigroup’s strategy of activity in all sorts
of financial services and in more than 100 countries worldwide, as well as its profit-
.making strategies, is influencing the profit expectations of the other world wide financial
firms.
3. On top of the world's multinationals
Compared to other multinationals, Citigroup is first on the Forbes 2000 list that measures
companies based on a composite of sales, profits, assets and market value. Financial
conglomerates take 60% of the top 20 companies in the world and more than 40% of the
top 100 companies. This shows the profit making capacity of the international financial
industry while it remunerates its managers and traders with excessive pay.
4. Current key trend of consolidation diverts efforts towards sustainable
development
The single most important factor transforming the financial services industry since more
than five years is consolidation. This trend is expected to continue and result in only five to
ten top financial conglomerates in the world within a decade. Top financial firms are now
acquiring many banks and other financial services in many countries. China, Central and
Eastern Europe and Russia are the new regions to be part of this trend. Domestic banks,
however large, that are not consolidating across sectors or across borders are expected to
loose out. The fierce international competition among the top financial industry to win the
battle of consolidation has lead to many cost saving and focus-on-the rich strategies.
The marginalization of the poor customers and the lack of attention to sustainable
development are thus part of the current key strategy within the financial industry. Making
the financial industry more instrumental to sustainable development and poverty
eradication might be difficult and contrary to consolidation that bends the sector to bigger,
faster, more.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 74
5. Risks need more attention
While the positive aspects of consolidation -more efficiency, lower prices and more choice
of new products - are highlighted, the (potential) negative consequences are still not
solved. Will financial firms become too big to fail and need intervention with taxpayers'
money when they mismanage? Will they become too big to compete and reduce choices
or abuse their market power e.g. by fixing prices among themselves? Already many forms
of strategic alliances and interdependence enhance the effects of consolidation contrary to
the 'free markets' which governments want to create.
6. Mismanagement of risks
The financial industry has gone through some rough years in 2001 and 2002 due to the
falling stock markets. Especially the loss making at the European insurance industry was
cause of concern. This means that the stability of the financial sector has been made too
dependent on the value of the stock market and that financial firms had mismanaged their
risks. If continued, this could have severe consequences. This mismanagement, together
with the recent scandals, calls for more regulation and supervision, which also should be
the case when they further expand to developing countries. The new upsurge in profits in
2003 might take attention away form these risks.
7. Focus on shareholder value, not on society
Consolidation has increased the focus on high shareholder value of the financial industry.
High shares mean less chances of being taken over. The constant focus on shareholder
value leaves little attention to sustainable development in the societies in which financial
firms operate. Not surprisingly, the industry stated in 1999 that the interests of society
should be taken care of by governments while they focus on share holder value
maximization (see chapter 4 for further developments on this issue). The latter makes the
shareholders the most influential stakeholders while they have little interest in sustainable
development and poverty eradication.
8. What will the future bring?
Possible scenarios for the future of the global financial industry are, without being mutually
exclusive:
The trend towards globally active universal financial service providers continues
with more cooperation among the few left. At the same time, mid-sized banks
disappear and the non-profit making countries and poor clients are less and less
served.
(Small) specialized financial firms survive: emergence of more functionally
specialized financial firms within a segment of the financial industry that survive
the competition of the large universal players.
Continued consolidation but a more radical form of specialization through the
gradual 'deconstruction' of the supply chain via the outsourcing of certain
activities (e.g. Internet services) to both financial and non-financial parties.
risks become too high and financial conglomerates destabilize economies;
regulators and supervisors -under pressure from public opinion- become more
active to discipline and undo the consolidation of the financial industry.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 75
1
Hoover's Industry Snapshots, Banking, 2003.
2
BIS, The international banking market, in Quarterly review, December 2003, p. 13, 18.
J
Top 1000 World Banks, in The Banker, 2 July 2003.
4
Europe slow to follow:the top 300 European banks, in The Banker, 3 September 2003.
5
See for instance: D. Wigton, Goldman’s record earnings round off bumper results, in FT,24 March
2004.
6
German News, English edition 26 June 2003,
(http://www.germnews.de/archive/dn/2003/06/26.html#9_)
7
BIS, 73rd Annual Report, p.104.
8
Lex Column, in The Financial Times, 25 September 2003, p.24.
9
S. Targett, Pension gloom is lifting, in FTfm, 19 January 2004, p. 2.
10
Insurance: risk management, The Financial Times Report, 1 October 2003, p.2; Lex Column, in FT, 25
September 2003, p.24.
11
Hoover's Snapshots, banking, 2003.
12
http://www.bankofamerica.com/facts/index.cfm?Menu_Sel=globalmap
1J
Top 1000 World Banks, in The Banker, 2 July 2003.
14
The Banker, Top 1000 world banks, 2 July 2004, through www.thebanker.com
15
M. Harmsen, De Nederlandse banken nemen posities op de Chinese markt in, in De Telegraaf, 22
August 2003.
16
Forbes 2000 list, March 2004, at: www.forbes.com
17
see World Bank, World Development Indicators database, July 2003.
18
Europe slow to follow:the top 300 European banks, in The Banker, 3 September 2003
19
Newcomers stand out in ranking of foreign banks in Latin America, quoting Foreign Investment in Latin
America and the Caribbean, ECLAC, 1998; confirming what newspapers are reporting up to 2003.
20
For a comprehensive profile, see SOMO's analysis of Citigroup at www.somo.nl
21
Top 1000 World Banks, in The Banker, 2 July 2003.
22
Citigroup, 2003 Annual Report, March 2004.
2J
H. Onno Ruding, The transformation of the financial services industry, Financial Stability Institute (Bank
for International Settlements), Occasional paper nr 2, March 2002, p. 12.
24
Citigroup not looking for a mega-deal, in Retail Banker International, 27 November 2003, p.2
25
Citicorp 4th-qrt profit rises 96% to 4.76 billion (update 3), Bloomberg.com, 20 January 2004; see also
Forbes 2000, March 2004.
26
www.citigroup.com/citigroup/business/index.htm
27
Citicorp 4th-qrt profit rises 96% to 4.76 billion (update 3), Bloomberg.com, 20 January 2004
28
Award from Institutional Investor, in: Citigroup 2003 Annual Report, March 2004
29
The Banker, Top 200 Asians, [December 2003], at
www.thebanker.inta.net.uk/rankings/top_200_asian[/index_print.shtml]
J0
see also www.oldmutual.com
J1
The Banker, Top 100 Sub-Saharan African Banks, December 2003; The Banker, South Africa still on
top, 2 December 2003.
J2
Analysis based on Het Financieele Dagblad, Kredietverlening aan grote projecten klimt uit het dal, 23
January 2003; based on data from Thompson Financial.
33
See www.thebanker.com
J4
Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 204, table 12.
J5
J. Kiff and R. Morrow, Credit derivatives, in Bank of Canada Review, Autumn 2000, p. 6.
J6
See: H. Onno Ruding, The transformation of the financial services industry, Financial Stability Institute
(Bank for International Settlements), Occasional paper nr 2, March 2002.
J7
M.Veeger, Italiaanse banken zijn boeven, in De Financieel Economische Tijd, 30 April 2003.
J8
M. Vander Stichele, Is de financiële crisis voorbij?, SOMO, November 1999.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 76
J9
Citicorp 4th-qrt profit rises 96% to 4.76 billion (update 3), Bloomberg.com, 20 January 2004
40
H. Onno Ruding, The transformation of the financial services industry, Financial Stability Institute (Bank
for International Settlements), Occasional paper nr 2, March 2002, p. 10.
41
One of the strategies is joint ventures as the Chinese authorities still prohibit full ownership and restrict
many financial services provisions by foreign financial corporations. These restrictions will be taken
away from 2006 onwards following agreement with the WTO (agreed during accession talks).
42
M. Harmsen, Nederlandse banken nemen posities op Chinese markt in, in De telegraaf, 22 August
2003.
43
The Banker, Foreign banks line up to invest in Chinese UCBs, October 4
th
2004; The Banker, HSBC’s
$1.75bn investment in Bank of Communications, February 2
nd
2005; The Banker, The winning ways of
a profit generator, December 1
st
2004; available at www.thebanker.com
44
Europe slow to follow: the top 300 European banks, in The Banker, 3 September 2003
45
See for instance: Bank Austria announces net income before taxes rises to EUR 280 million for 2002,
in The Asian banker Journal, 31 March 2003. See also http://thebanker.pressflex.com: Bank Austria
Creditanstalt received the The Banker award for Central and Eastern Europe.
46
N. Guy, [n.a.], in Euroweek, 14 March 2003, p. S2. In Western Europe, more than 90% of the adults
have a bank account. Russians keep at least $ 60bn worth of hard currency, principally dollars in
hiding.
47
See for instance BIS, Foreign direct investment in the financial sector of emerging market economies,
Report submitted by a Working Group established by the Committee on the Global Financial System,
March 2004.
48
Frankfurter Rundschau, 31 July 2003.
49
See for instance: F. Maguire, Research highlights lack of core banking systems, in Financial News, 2
July 2003.
50
M. Sisks, Consolidation: web techies brace for M&A storm, in Bank Technology News, July 2003, vol.
16, nr. 7, p. 12.
51
BIS, The international banking market, in Quarterly review, December 2003, p. 14.
52
Group of Ten, Report on consolidation in the financial sector, January 2001, p. 2.
5J
T. Major, F. Gimbel, Germany flocks to one-stop shops, in FTfm, 16 September 2002, p. 7.
54
I. Wylie, A modern industrial revolution, in The new new deal, a guide to global investing online,
sponsored by Merill Lynch HSBC, supplement, May 2001, p.4.
55
Basel Committee on Banking Supervision, Outsourcing in Financial Services, February 2005, at
www.bis.org
56
M. Canoy, M. van Dijk, J. Lemmen, R. de Mooij & J. Weigand, Competition and Stability in Banking,
CPB (Netherlands Bureau for Economic Policy Analysis) Document nr. 015, December 2001.
57
See for instance H. Onno Ruding, The transformation of the financial services industry, Financial
Stability Institute (Bank for International Settlements), Occasional paper nr 2, March 2002, p. 15.
58
Myriam Vander Stichele, De rol van internationale banken bij 'pro-poor growth', a SOMO paper in
preparation of the debate on Ondernemen tegen armoede, The Hague, January 2001.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 77
Chapter 3
The case of Indonesia
Introduction
There are some issues in the private financial sector that are particular to developing
countries and which are important from a perspective of poverty eradication and
sustainable development. This chapter is a summary of a case study of the financial
services sector in Indonesia by Business Watch Indonesia
1
and raises some specific
critical issues.
3.1 Domination of the banking sector compared to other
financial services
In Indonesia, as in many developing countries, the banking sector dominates the private
financial sector. Not many other financial services are offered. Rarely are insurance
services provided to individuals and companies. So, the banking sector is an important
motor for business life and economic development.
Table: Map of the financial sector in Indonesia in 2002
Rank Sector Controlling market share
(%)
1 Banking 90.46
2 Insurance Company 3.38
3 Pension/Pension Fund 3.01
4 Multi-finance company 2.31
5 Securities Company 0.65
6 Pawn shop 0,20
Source: Business Watch Indonesia, based on InfoBank, Nr. 292 - August 2003, Vol.XXV.
3.2 The role of banks in servicing the poor
3.2.1 Weak support for small and medium sized enterprises
Small and medium sized enterprises (SMEs) provide the greatest number of jobs in
developing countries and are an important stimulus to national economies. However,
lending to SMEs is only a tiny part of private banks’ lending portfolio. Also, interest lending
rates charged to SMEs are often higher than those offered to larger firms because SMEs
are considered riskier. In Indonesia, total annual credit delivered to SMEs between 1998
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 78
and 2003 was never more than 21%. During this period, the credit offered to SMEs
increased after regional decentralization, allowing for regional governments to develop
their own lending policies.
Table: Credit delivery to SMEs compared to Total Bank Credit
Year Credit
delivered to
SMEs
Total
Delivery
Credit
Credit
delivered to
SMEs
Total
Delivery
Credit
Total (%)
(Million Rp.) (USD Million)
1998 43.870 487.426 5.223 58.027 9.00
1999 37.240 225.133 4.433 26.802 16.54
2000 55.840 269.000 6.648 32.024 20.76
2001 61.160 307.594 7.281 36.618 19.88
2002 60.840 365.410 7.243 43.501 16.65
March 2003 62.080 376.141 7.390 44.779 16.50
Source: Business Watch Indonesia, based on Monthly Report of Bank Indonesia, May 2003
In Indonesia, state banks, rather than private ones, most actively offer credit to the SME
sector. In March 2003, 55.4% of the total credit to SMEs was provided by the national
state banks, and 18.5% by regional state banks. Private banks provided 25.9% (down
from 29.8% in 1998) of the credit to SMEs in the same period.
This contrast between private and state banks lending practices vis-à-vis SMEs is often
not discussed in terms of the privatization of banks (see below).
3.2.2 The role of banks and the poor
The Indonesian case study research shows that only 14.3% of loans for small and
household handicrafts comes from banks with the rest coming from individuals, family and
money lenders.
Table: Source of main loans by SMEs and household handicrafts (1999, Million Rp.)
Bank Coope-
rative
Non-Bank
Financial
Institutio
n
Venture
Capital
Indi-
vidual
Family Others Total
Total
Enterprise
64,275 14,603 9,122 2,040 138,992 58,733 163,035 450,800
% 14.26 3.24 2.02 0.45 30.83 13.03 36.17 100
Source: Business Watch Indonesia, based on Statistic of Small Industry and Household Handicraft,
Central Bureau of Statistics or Badan Pusat Statistik (BPS), Jakarta - Indonesia, Year 1999
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 79
Few SMEs and household handicrafts take loans from banks because:
they are not interested or unwilling to use banks to get loans;
they lack collateral;
they do not know about or understand the procedures and are intimidated or
untrusting;
they do not meet the requirements.
Remember, many small companies exist within the informal economy and therefore are
not integrated in the Indonesian banking system. The advantage is that those in the
‘informal’ sector were protected from the financial crisis in 1997-98 because their assets
were not tied up in the banks.
Critical issues
To what extend can the banking system stimulate the alleviation of poverty
through SME loans? Or are other financing instruments are more efficient?
3.2.3 Foreign banks give little or no credit to poor
Foreign banks provided 0.005% of their total credit to SMEs in Indonesia in 2002 and
beginning 2003. This reflecting a downward trend as total SME credit by foreign banks
was 0.28% in 1998. Contrary to examples in Latin America and arguments from the
World Bank that claims that market opening increases efficiency, in practice there seems
to be nothing gained by SMEs in Indonesia.
Micro-credit organizations, established because national banks did not service the very
poor, provide very small loans to people, mostly women, without collateral. Formal banks
claim the costs to administer such loans are too high. The success of such examples of
Grameen banks is however a proof that the poor can be a good credit risk. The micro-
credit schemes in Indonesia are supported amongst others by the World Bank. Citigroup
is also supporting micro-credit NGOs through its Grameen Trust and it’s Community
Programme in Indonesia (Citibank Peka)
2
while its regular commercial financial services
focus on the big cities and richer Indonesians.
3.2.4 Neglecting poor regions
One of the problems with the financial industry is that they only set up in areas and
regions where the economy is already strong and where it can make profits. This means
that the majority of bank credit allocation is concentrated in the capital Jakarta and in the 5
biggest and most developed provinces. The area of Jakarta was still the biggest recipient
of credit in 2003 (39% of all credit in Indonesia), but the amount lent was about half of the
credit allocated to Jakarta in 1998. The credit to Jakarta in 2003 was still three times that
allocated to East Java, the second ranked recipient of bank credit.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 80
Table: Annual credit delivery (compared to overall national credit)
Province level
1
1998 1999 2000 2001 2002 2003 Change
’98-
DKI Jakarta 71.1% 60.7% 43.6% 39.1% 39.1% 38.73% -32.40%
East Java 7.5% 8.6% 14.0% 14.7% 13.4% 13.52% 6.06%
West Java 5.8% 8.3% 10.4% 11.1% 10,6% 10.12% 4.29%
Central Java 3.2% 4.7% 5.7% 6.9% 7.0% 6.76% 3.54%
North Sumatra 2.4% 3.2% 4.4% 4.7% 4.8% 5,20% n.a.
Source: Business Watch Indonesia, based on Monthly report of Bank Indonesia, May 2003
The figures do not show that foreign banks also establish operations and provide credit in
the regions that are the most economically advanced. Citigroup for instance, has eight
main offices in Jakarta and four throughout the rest of the country.
J
3.2.5 Increase in consumer credit rather than investment
credit
The BWI Indonesian case study indicates that between 2001 and June 2003, banks have
been focusing more on channeling credits to the consumer sector. Consumer credit has
increased 117% since the end of 2000 and held 22% of total credits by June 2003, up
from 14% of total credits, at the expense of credit for business investment.
Some banks allocate in total much more credit to the consumer sector than to the
investment sector. PT Bank Tabungan Negara, a state bank, gives 95 % of its credit to
consumer credits. The Bank of America operating in Indonesia only gives credit for
consumptive purposes.
Indonesian banks mostly give credits for business investment to those who have already
been running a business. So the proportion given for new investment is very small. Even
though encouraging consumption can stimulate economic growth, investment for business
is also crucial for the Indonesian economy to recover from the stagnation which resulted
from the 1997-98 financial crisis.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 81
Table: List of the banks with the largest consumption credits (June 2003)
Bank Credit Modal Kerja
(credit for working
capital/cash) (%)
Credit for
investment
(%)
Consumption
(%)
Status
1 PT Bank Rakyat
Indonesia
56.97 9.51 33.52 State bank
2 PT Bank Tabungan
Negara
4.61 0.25 95.14 State bank
3 PT Bank Danamon
Indonesia
45.23 22.63 32.13 bank taken
over
4 PT Bank Negara
Indonesia
50.62 35.13 14.25 State bank
5 Citibank N.A. 63.95 0 36.5 Foreign bank
6 PT Bank Central Asia 70.17 16.05 13.78 bank taken
over
7 PT Bank Permata Tbk 35.24 37.26 27.49 bank taken
over
8 PT Bank Mandiri 52.41 44.41 3.18 State bank
9 Bank International
Indonesia
28.40 46.91 24.69 Recapitalised
bank
10 PT Bank NISP 28.02 47.55 24.43 Recapitalised
bank
11 HSBC 74.67 10.62 14.71 Foreign bank
12 Standard Charterd
Bank
77.25 0 22.75 Foreign bank
13 ABN Amro Bank 82.51 0 17.49 Foreign bank
14 PT Lippo Bank 76.67 11.76 11.57 Recapitalised
bank
15 America Express
Bank Ltd
70.18 0 29.82 Foreign
16 Deutsch Bank AG 91.31 4.62 4.07 Foreign
17 The Bank of Tokyo-
Mitsubhisi Ltd
91.74 7.73 0.52 Foreign
18 The Chase
Manhattan Bank N.A
98.39 0 1.61 Foreign
19 Bank of America, N.A 0 0 100.00 Foreign
20 The Bangkok Bank
Corp. Ltd
79.15 20.73 0.13 Foreign
Source: Business Watch Indonesia, based on Investor Magazine Edition, Nr. 84, Year-V, 20 August
– 9 September 2003.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 82
3.3 Deregulation and the lack of regulatory and
supervisory capacity
Regulating financial services is complex and requires human and financial resources to
draft legislation, implement and enforce regulations. Deregulation and the relaxing of
banking rules in Indonesia, starting in 1988 and promoted by the IMF and World Bank,
made it easy to set up new banks. As a result, there was a great increase in new banks
and branches.
The 1997-98 financial crisis exposed the fact that many of the new banks were run by
businessmen with no banking knowledge or experience. To make matters worse, these
businessmen used the banks to finance their own businesses, violating lending limits
while manipulating the books.
With no supervisory authority intervening and so much corruption and bad governance,
some banks with bad loans were liquidated or restructured by the state that put money
into some of those banks that could be saved. The government paid out huge amounts of
cash, taxpayers' money, in the restructuring process, money that could have been better
spent on the many human, social and environmental costs of the crisis.
The financial sector restructuring process was supposed to be finished at the end of 2003
when the IMF program ended but new regulations and supervisory institutions were still
being debated in Parliament at that time. In the rush to complete the restructuring many
bad loans were liquidated with not enough compensation for the government's input.
The challenge is to ensure that the government does not provide more blanket guarantees
for bad loans and bad banking activities, that corruption is halted and banks remain
outside of politics. The financial sector’s institutional framework in Indonesia is still
unstable and creating the right framework is, politically and economically, difficult.
3.4 The critical roles of lending by foreign banks
3.4.1 The role of lending by foreign banks in the financial
crisis
The South East Asian crisis was not caused only by the corrupt system and lack of
regulatory and supervisory capacity in Thailand, South Korea and Indonesia, but also
because foreign banks lent credit in foreign currency. Some foreign banks did even not
have offices in these countries but they risked making short-term loans to banks and
companies in these South East Asian countries. They wanted to take a slice of the market
and they assumed the governments would intervene in case of problems. The domestic
banks and Indonesian business people also happily took loans from foreign banks at
much lower interest rates than from their domestic counterparts.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 83
However, once it became apparent that the reserves of foreign currency needed to repay
the short-term loans, were insufficient, the Thai currency crashed and each country
followed. The governments first took IMF loans to support the local currency and prevent
devaluation. Remember liberalizing capital flows and financial industry instruments leads
to capital flight and speculation in times of financial crisis, and the devaluation of local
currency against the foreign currency. Many of the loans from foreign banks were made in
foreign currency. When the local currency crashed, foreign currency became way too
expensive and default on loans in the foreign currency was inevitable. But the loan the
government took out to boost up the local currency had become more expensive to repay
after the devaluation, which meant that the government of Indonesia with a double burden
of loan repayment in foreign currency. It needed to pay for bailing out the private banks
as well as debt to the IMF, which means the Indonesian authorities had less to spend on
anti-poverty projects and improving their capacity to govern. At the same time, financial
and political restructuring to date, has not resolved many problems of corruption.
3.4.2 Odious governmental and private debt
Western governments and international governmental organizations, including
development banks and the IMF, alongside private banks were lending to the corrupt and
dictatorial Soeharto regime for years. Before the fall of Soeharto’s regime in 1996,
governmental debt was US$ 55.3 bn, of which $ 1 bn was due to private banks. After the
financial crisis and the collapse of the regime, Indonesia's official debt was US$ 77.9 bn
(2003) of which US$ 2.3 bn was due to commercial loans.
4
The Soeharto government had also raised money from private investors by issuing bonds.
The bond market is interesting to foreign institutional investors including pension funds
and mutual funds. By the time the Soeharto regime collapsed, most of the bonds issued in
the 1970-80s were repaid but new bonds issued had been issued in 1986 and 1996
(including the "Indonesian Yankee bond").
5
By September 2003, the total amount that the
government had to repay to bond investors was US$ 736 million.
In addition, the total external debt by Indonesia's private sector (banks, companies, etc.)
was around US$ 53.6 bn in September 2003.
6
At that time, external debt by Indonesian
private and state owned banks was estimated at $ 4.4 bn, part of which was owed to
foreign banks. Indonesian 'non-bank' financial companies had to pay an estimated $ 2.9
bn to foreign creditors. The private sector also issued securities that were bought by
foreign investors, totalling an estimated $ 1.3 bn in September 2003.
Civil society organizations have called for the cancellation of government debt after the
collapse of the corrupt Soeharto regime.
7
If there is no debt cancellation, the citizens and
the new regime will bear the debt burden and will have to repay loans, which were
unethical and very risky ('odious debt'). Corrupt regimes often misallocate loans and
cannot repay but civil society feels the lenders should bear the burden of this odious debt,
and not the population.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 84
Research shows that the foreign banks also make loans to corrupt companies, projects
and banks in Indonesia, which are risky and unethical. Full repayment of this private debt
could result in following through with projects that are very detrimental for the environment
and population, in order to generate the profits to make the repayments. The foreign
currency needed to repay the private debt also undermines an economic and monetary
policy that prioritizes domestic needs.
Total Indonesian governmental and private debt, and securities, that are due to foreign
creditors and foreign investors was estimated at $ 132.7 bn in September 2003 - higher
than the year before.
8
The private and governmental lending institutions do not agree with
cancelling or writing off governmental debt. The Paris Club, which is a forum where
governments and the international financial institutions negotiate the restructuring or
cancellation of the debt of developing countries, has discussed some rescheduling and
restructuring but not debt cancellation.
The foreign and international governmental institutions that are owned debt from
Indonesia belong to the Consultative Group of Indonesia. Negotiations on rescheduling
the government's debt from private banks have taken place at the London Club, a group
of international commercial banks. Members of the Consultative Group had pressured the
private sector to also reschedule private debt of Indonesia. In August 2002, the London
Club put forward an agreement with the Indonesian government to reschedule US$ 1.3 bn
in private debt.
9
The London Club's steering committee listening to the official arguments
included the five major creditor banks:
Bank of Tokyo-Mitsubishi,
BNP Paribas SA,
Commerzbank Aktiengesellschaft,
Hongkong and Shanghai Banking Corp. (HSBC), and
Mizuho Corporate Bank Ltd.
Eventually all the commercial banks involved in the private debt of the Indonesian
government had to give approval.
10
The London Club would however not reschedule the repayment of the "Indonesian
Yankee bond" because of a particular clause included in the conditions of the bond.
11
Orderly debt restructuring and equitable sharing of risks between issuers, underwriters
and investors of bonds has so far not been successful and there are no debt cancellation
instruments currently even available at the international level.
12
Civil society hardly monitors governmental debt to foreign bond owners and foreign banks
but the truth is, very little information is even transparent. Usually, creditor banks form a
consortium that negotiates with an indebted bank or company to restructure the terms of
repayment of the debt, aiming at the full repayment.
The Indonesian government's willingness to repay odious debt is due in part to its concern
about its credit rating. Standard & Poor and Moody’s grade countries for creditworthiness.
While debt rescheduling with the Paris club tends to upgrade a rating, rescheduling with
the private creditors more often leads to downgrades from the rating agencies.
13
The
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 85
lower the grades, the more the government and the private sector pay in interest rates to
banks for new loans.
At the beginning of 2004, investment banks were pushing the Indonesian government to
again issue $1 bn in new bonds. The government was reluctant to follow the advice,
preferring to err on the side of caution.
14
Both sides have clearly different interests at
stake: the government would increase its debt and probably decrease its spending to the
population or increase it in the long term, while the investment banks get income from
underwriting bonds but risk their reputation in case of default of repayment.
3.5 Private project and company financing carried over to
governments
The private financial industry has provided financing for Indonesian companies and
projects in the mining sector, the pulp and paper industry, and logging and palm oil
plantations. Corruption, environmental devastation and ensuing social upheaval, in each
of these sectors, have been rampant. The loss of old forests, species and biodiversity has
been increasingly documented.
Private banks, both domestic and foreign, and other financial firms have used different
instruments to finance these companies and projects, including:
15
syndicated loans for project lending,
bank credit facilities for activities and expanding a business,
securitization of loans, and,
underwriting new bonds and securities, and trading in project bonds and
securities.
The World Bank and ECAs, export credit agencies, have also provided financial support to
these devastating projects and corrupt companies. This financing from governmental
bodies has stimulated private financiers to join the financing of these Indonesian projects
or companies.
16
ECAs have been created to provide guaranteed credits and loans to Western companies
looking to send exports to developing countries. Now, they also provide guaranteed
investments to (exporting) companies in developing countries.
The guarantee of repayment, in case the investment or export goes wrong, is given to the
exporting companies as well as to banks that finance the exporting companies.
In other words, the governments, through taxpayers' money, assume the risks taken in
developing countries by the Western financial industry. In the case of Indonesia, many
ECA-guaranteed projects and exports went wrong, not only financially but also because
they turned out to be very destructive to the environment and harmful to the population.
The ECAs guaranteed that the Indonesian government had to repay the bad loans, which
increased Indonesia's governmental external debt by $ 17.5 bn!
17
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 86
What is an Export Credit Agency (ECA)?
An export credit agency provides government-backed export credits in the form of loans, and
guarantees or insurance for loans and investments. ECAs support exports and direct
investments in developing countries and emerging markets by corporations based in the ECA’s
home country. Usually overseen by the finance, trade, or economics ministry, an ECA uses
taxpayer money to make it cheaper and less risky for domestic corporations to export or invest
overseas. Some ECAs are privately owned but entrusted with handling credit guarantees of the
government. Almost all industrialized countries have at least one ECA. Like department stores
that provide credit so people without cash will buy the stores’ products, rich countries (through
their ECAs) provide loans and credit to developing countries, so that they will buy the rich
country’s exports.
Many ECAs offer direct loans, or, when commercial banks or exporters provide the loans or
credit, ECAs provide guarantees or insurance -essentially promises to reimburse the banks or
exporters and cover most losses. ECAs offer lower interest rates, premiums, and fees than the
private market would--and can also back transactions that the private market would refuse. But
for developing-country borrowers, ECA-backed loans are still at higher interest rates than many
loans from other official sources like the World Bank or the International Monetary Fund (IMF),
or other development banks and aid agencies. The results include debt for poor countries and
increased sales and foreign investment opportunities for multinational corporations based in
wealthy countries.
Few people recognize the scale and importance of ECAs’ role in the global economy. One ECA
enthusiast calls them “the unsung giants of international trade and finance.” In 2001, ECAs
covered $ 455 bn worth of business transactions with export credit insurance and $ 17 bn with
investment insurance. In comparison, the entire World Bank Group’s commitments in 2000
came to only $19.3 billion, and all official development assistance commitments from the global
North to the global South amounted to only $62.2 billion. Furthermore, despite recent
downturns related to the Asian financial crisis and September 11 attacks, export credits to
developing countries have been growing over the long term, while development assistance has
declined or remained stagnant.
Indeed, the increasing role of ECAs in the global economy -directly backing hundreds of billions
of dollars of international trade and investment and leveraging much more in purely private
flows- raises the question of the extent to which government intervention through ECAs has
actually driven the process of economic globalisation.
Not only are ECAs by far the single largest part of public financial flows from North to South,
but they are also the least examined, the least transparent, the least accountable, and, in some
ways, the most harmful.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 87
Among the issues critics of ECAs raise, are that they:
lack basic safeguards against environmental destruction, breach of human
rights, and corruption,
undercut governments’ developmental and environmental policies and
multilateral agreements,
contribute heavily to developing countries’ debt burdens,
have little or no transparency or accountability,
provide corporate welfare by passing business’ risks and losses on to
taxpayers,
contribute significantly to arms trade, expansion of nuclear power, and
global warming,
support destructive projects that even the World Bank would not touch.
Source: CIEL, Export credit agencies and the WTO, November 2003; Business Watch Indonesia
based on http://www.foodfirst.org/pubs/backgrdrs/2003/w03v9n1.html
Domestic banks, state owned and private ones, in Indonesia have been financing many
corrupt and destructive Indonesian companies. Some Indonesian banks were plagued
with corruption themselves. The Asian crisis in 1997-98 rendered loans to, and securities
of, these bad performing companies worthless. In order to avoid a total collapse of the
banking system and the wider economy, the government of Indonesia was forced, also by
its donors, to restructure domestic banks. The government assumed much of the bad debt
and created the Indonesian Bank Restructuring Agency (IBRA) to deal with restructuring
the debt and recuperating the assets related to the loans. However, the IBRA recuperated
much less than the amount of money invested by the government in recapitalizing failing
banks and assuming the bad debt. As a result, the reckless and corrupt lending by
domestic banks, sometimes financed by foreign banks, lead to a huge budget deficit.
State spending for recapitalization and debt restructuring has been at the expense of
spending to meet the social needs of the country.
3.6 Privatization
3.6.1 Privatization of the banking sector
Many banks in Indonesia have been inefficient, poorly managed and corrupt,
18
had low
profit margins, and offered bad service. They include under-performing state banks that
were supposed to ensure universal access and fair service for all citizens while at the
same time allocate money for the benefit of the development of the domestic economy in
situations where private banks don’t. This situation in Indonesia has parallels in other
developing countries.
In the case of Indonesia, it became clear after the financial crisis that the state banks were
recklessly run while foreign owned banks were more prudently managed.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 88
Table: Bank Categorization in Indonesia after the financial crisis (1999)
Groups of banks
Category A Category B Category C Total
State owned banks - - 7 7
National private banks 32 62 34 128
Take Over banks (BTO) - - 4 4
Local Govt. Dev. Banks 12 10 5 27
Mixed banks (Domestic and
foreign)
12 16 4 32
Foreign Banks 10 - - 10
Total 71 78 59 208
CAR: Capital Adequacy Ratio or bank health indicator
Category A: good business prospect; adequate capital reserves more than 4%
Category B: business prospect not good; adequate capital reserves less than 4% and more than -
25%
Category C: there is little business prospect; adequate capital reserves less than -25%.
Source: Business Watch Indonesia, Sector report, table 8.: based on information from Bank
Indonesia Annual Report, 1999
The IMF has pressed, as loan conditions, for the privatization of banks due to the poor
performance of these Indonesian state-run banks. The privatization of state banks was
done by finding investors for strategic alliances and by selling shares to the public.
However, shares and assets were sold at rock bottom prices, far below the amount of
money injected in these banks by the government before privatization. In the new strategic
alliances, the government often lost control over the privatized bank.
3.6.2 Financing privatization by the financial industry
The IMF, World Bank and donors have been arguing for the privatization of public services
including telecoms, postal, energy, health, education and water precisely because many
developing country public services are a mess and are hugely loss-making, offer poor
service, are inefficient and significantly contribute to budget deficits and rising debt.
The benefits of privatization are subject to hot debates. Proponents ignore
19
those cases
where prices have increased, distribution is more limited and excludes the poor, and
where governments loose control over resources needed to fulfil basic human rights
obligations such as universal health care and water distribution.
While the benefits and results of privatization are still debated in Indonesia,
20
private
financial firms have supported privatization by:
providing debt restructuring services
21
before the public services are offered for
sale,
giving advice to companies that want to buy the privatized companies,
providing loans to companies (often transnational corporations) that are buying up
the privatized public services, and
issuing shares and bonds
22
for privatized companies.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 89
3.7 Critical issues related to labour in the private financial
sector
In the context of poverty eradication, the financial industry could play a role in providing
jobs and good labour conditions. Indonesia's experience shows that the industry's
contribution might not be better than in other sectors while the presence of foreign banks
might make things worse.
3.7.1 Lay offs
Privatization and restructuring after the financial crisis led to massive lay offs. It is
estimated that in Indonesia around 5600 workers were made redundant when 16 banks
were liquidated in 1997. Given the low confidence in the banking system and the
economy, not many jobs were created afterwards.
3.7.2 Not respecting labour laws
In many industrialised countries the banking sector is a fair employer with relatively high
salaries and good-working conditions compared to many other sectors, but this is not
usually the case in developing countries. For example, Bank Negara Indonesia (BNI),
Indonesia’s second largest bank violated the regulations and law pertaining to ‘contract’
workers, which is common practice in Indonesia. Temporary contracts did not become
permanent contracts after three years, as required by law. Employees with temporary
contracts have no protection of their labour rights and an unclear status.
3.7.3 Discrimination between foreign and domestic
employees at foreign banks
There is evidence of discrimination between local and foreign employees when foreigners
move into management positions in developing countries. When Standard Chartered Bank
took over management of Bank Bali in Indonesia, wages and lifestyle of the expatriate
management was dramatically higher than for local staff, despite a worsening economic
situation of Bank Bali. In addition, discriminatory allocation of bonuses by Standard further
offended many domestic employees and managers of Bali Bank.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 90
3.8 Conclusions: critical issues for developing countries
The case study of the financial sector in Indonesia revealed some particular critical issues
of the financial services sector that are particular for developing countries:
1. Low financing levels for small and medium-sized enterprises, particularly by foreign
banks.
2. Reluctance by small or informal producers and the poor to take a loan from a bank.
3. Concentration of presence of national and foreign financial services in the
economically better developed regions and the political centres.
4. Changing focus of banks to consumer credit rather than credit for investments in the
economy.
5. The lack of regulatory and supervisory capacity, aggravated by corruption, has
resulted in huge amounts of bad loans being taken over by the authorities, and to the
restructuring of the financial sector; this has cost billions of dollars in taxpayers'
money that could not be spent on needs of the poor and the environment.
6. Lending by foreign banks to banks and companies in developing countries can be
large and be too risky, resulting in a financial crisis.
7. The Western financial industry is involved in the external debt of developing countries
through loans, underwriting governmental or company bonds and company shares.
While the debt owed by the Indonesian governmental to commercial banks and to
bondholders is far below debt owed to other (international) governmental
organisations, the external debt by the Indonesian private sector is relatively high
compared with the external debt by the government. Together, the huge external
governmental and private debt has an important influence on foreign exchange
management and economic development (e.g. focus on exports for foreign exchange
earnings rather than for domestic consumption).
8. Developing countries are dependent on Western credit rating agencies to obtain new
loans.
9. (Governmental) agencies that provide financial guarantees for trade with and
investment in developing countries protect foreign lenders and investors against non-
payment, while the financial burden is left with developing countries, further increasing
their external debt.
10. Privatization of national banks allow the domestic and foreign private financial industry
to take over the whole financial sector of the country. In this way, Indonesia becomes
part of the consolidation wave of the top world financial firms.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 91
11. Financial firms provide several services to support and finance privatization of
essential services even if the benefits for the population is controversial and not
guaranteed.
12. There are different problems related to labour in the private financial industry:
Non-respect of labour laws.
Discrimination between domestic and foreign staff of a financial firm.
Corruption scandals result in (innocent) employees to be laid off to restructure the
troubled bank.
1
The financial sector study by Business Watch Indonesia (BWI) is published separately of this financial
sector report and contains much more details of the issues described in this summary. The sector and
country studies about the financial sector can be viewed in English on Somo's website www.somo.nl,
or a copy of the report can be requested from SOMO or Business Watch Indonesia (BWI). Information
and data mentioned in this chapter comes from the BWI case study except otherwise referred to.
2
http://www.citibank,com/indonesia/gcb/english/peka/index.html
J
www.citibank.com/indonesia/gcb/english/services/branch.html
4
Bank Indonesia, Public & private sector external debt, [November 2003], at www.bi.go.id
5
Bank Indonesia, Indonesian government bonds in international capital market, 7 November 2003, at
www.bi.go.id
6
Bank Indonesia, Public & private sector external debt, [November 2003], at www.bi.go.id
7
See by INFID: www.infid.org
8
Bank Indonesia, Public & private sector external debt, [November 2003], at www.bi.go.id: this amount
includes the figures mentioned in the paragraphs above.
9
Indonesia credit rating upgrade "imminent", S&P says, at www.bi.go.id/iie/news.asp?New=57
10
Indonesia credit rating upgrade "imminent", S&P says, at www.bi.go.id/iie/news.asp?New=57
11
Japan Credit Agency, Indonesia's Official External Debt Rescheduling Agreed, April 15, 2002 (viewed a
thttp://www.jcr.co.jp/topics/indoe.htm : 'at the London Club… the Yankee bonds due 2006 will not be
included in the debts to be restructured under "comparability of treatment" provision in the agreement."
12
Government gearing up for London Club meeting, in The Jakarta Post, 16 april 2002, view at
http://www.nafed.go.Id/news/Index.php:artc=16J
1J
Indonesia credit rating upgrade "imminent", S&P says, at www.bi.go.id/iie/news.asp?New=57;
Government gearing up for London Club meeting, in The Jakarta Post, 16 april 2002, view at
http://www.nafed.go.Id/news/Index.php:artc=16J
14
S. Donnan, Jakarta set to appoint banks for bond issue, in FT, 19 January 2004.
15
For further explanation, see chapter 1.
16
I. Altmeier, F. Irawan, S. Fried, R. Noor, Summary: Double destruction - The role of ECAs in
Indonesia's forests: from pulping the people to looting for palm oil while destroying US jobs, May 2002,
at www.eca-watch.org/problems/
17
Bank Indonesia, Public & private sector external debt, [November 2003], at www.bi.go.id: estimates for
September 2003; the ECA debt was US$ 16.9 bn in June 2003.
18
Business Watch Indonesia, sector study, chapter 1.3.2.: in Indonesia, some of the banks were owned
by the former president Soeharto's family such as Bank Andromeda, Bank Industry and Bank Jakarta.
19
See for instance examples of problems in many developing countries reported in Social watch report
2003 - The poor and the market, Uruguay, 2003.
20
NGO warns of unrestrained privatisation of public service, in The Jakarta Post, 14 February 2003.
21
See the case study of ING Group in Indonesia at www.somo.nl
22
Business Watch Indonesia, sector study, chapter 1.3.2.: underwriting by international investment banks
for telecommunication company Indostat and State Gas Company
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 92
Chapter 4
Corporate Social Responsibility
initiatives in the financial services
sector
Introduction
The private financial sector has an important role in discussions about corporate social
responsibility (CSR) and corporate accountability. By intermediating financial flows, many
financial firms raise, allocate and price capital as well as provide risk coverage for
businesses.
Increasing attention of the role banks play in business operations or large projects that
lead to human rights violations and environmental degradation has helped to open the
discussion of ‘accountability’ of these financial firms. The private financial sector, however,
includes a diverse group of sub-sectors, ranging from commercial and investment banks,
asset management institutions, reinsurance and direct insurance groups.
Apart from overall CSR initiatives covering all corporations in all sectors of the economy,
there are many specific initiatives that aim at setting voluntary CSR standards for the
financial sector. Some of these CSR initiatives cover all the activities within the financial
services sector, while others relate to some particular sub-sector financial activities such
as insurance.
Most of these private sector specific CSR initiatives can be divided into three areas:
1. How financial firms operate in-house: the social and environmental aspects of their
own operations such as labour and work conditions, recycling and energy
consumption.
2. How policies, services and products of financial firms impact society: the social,
human rights and environmental impacts of, for instance, projects financed by banks
or bonds issued by an investment bank. CSR initiatives relating to the impact of
financial services can also cover the way in which financial firms operate, e.g. the
terms an insurer uses to assess the risk of a company. These initiatives often focus
on how CSR principles are managed (not what their actual effects are).
3. How financial firms actively promote sustainable development: financial firms can be
pro-active and support socially and environmentally friendly developments, e.g. by
designing new products that favour better social or environmental practices. Such
products might be, for example, loans with lower interest rates for companies with a
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 93
proven social and environmental record. Financial firms can also advocate for more
sustainable practices among their colleagues within the whole financial industry.
This report does not include a fourth area, charitable initiatives by financial firms. SOMO
views that charitable activities would not be necessary if CSR would cover the core
business of any company and if all firms paid enough taxes.
Once CSR initiatives are underway and guidelines determined, reporting by financial
firms on the social, environmental and/or sustainable development aspects of their
activities and the implementation of the CSR principles to which they subscribe, is
necessary. Reporting initiatives of financial firms are described at the end of this chapter.
They reveal that most do not disclose the concrete social and environmental impacts of
their financing activities, but rather promote in-house policies and new ‘sustainable’
products, which makes evaluating the effectiveness of many financial CSR initiatives
impossible. Full reporting could however take CSR a step further to full implementation
and external verification.
This report does not assess the many different codes of conduct, business principles or
mission statements made by the different banks themselves. Neither will this report review
all the national initiatives underway, for instance by branch organizations of the financial
industry.
This chapter gives an overview of CSR initiatives at the international level that are
specific to the financial sector. This chapter is divided per sub-sector in the financial
services industry (for definitions see chapters above) but starts with those CSR initiatives
relating to all financial services.
4.1 CSR initiatives and guidelines covering all financial
services
There have been several international efforts to draw up CSR guidelines that would apply
to all activities of the financial services industry. In practice, guidelines are voluntary and
only apply to those in the industry that signed up to such initiatives.
Important allfinanz CSR initiatives, sponsored by only part of the financial industry, are the
EPI-finance project, the UNEP Statement by Financial Institutions on the Environment and
Sustainable Development, a statement by CEO’s of financial firms belonging to the World
Business Council on Sustainable Development (WBCSD) and The United Nations’ Global
Compact’s supplement on the financial sector.
In 2003, NGOs drew up The Collevecchio Declaration, which proposes a radically different
approach to corporate social responsibility in the financial sector than earlier industry
driven CSR initiatives.
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 94
4.1.1 UNEP Finance Initiative
1
From 1992 onwards, the United Nations Environment Program started to engage financial
firms and institutions in a dialogue on economic development, environmental protection
and sustainable development, through its Finance Initiative
2
(UNEP FI).
The mission of UNEP FI is to work with financial companies and institutions to identify,
define and promote good and best environmental practice in their internal and external
operations.
UNEP FI is a collaboration of more than 200 commercial and investment banks, insurance
and re-insurance companies, fund managers, multilateral development banks and venture
capital funds. UNEP does not manage the project and does not hold the budget. NGOs
are not the main partners of the initiative. NGO involvement has been permitted
occasionally, usually after letters of protest.
UNEP FI originally included two distinct parts: (a) the Financial Institutions Initiative and
(b) the Insurance Industry Initiative. Each of these initiatives is based on a related
statement of commitment to sound environmental and sustainability management
principles. (for the Insurance initiative and statement, see below).
The two initiatives were merged to become the UNEP Finance Initiative during the UNEP
FI Annual General Meeting in October 2003. Participants of the initiative still sign either of
the statements, depending on their core activities.
The “UNEP Statement by Financial Institutions on the Environment and Sustainable
Development”
3
This statement was established in 1992 and revised in May 1997 to include other financial
institutions than just banks. It focuses on the commitment of financial enterprises on
environmental sustainability in the three areas of their activities.
Internal operations, including energy consumption, resource efficiency and
waste recycling. These issues are frequently used to gain support from the
company’s management and to ‘green’ the office culture, because some gains
can be shown through cost reduction.
The Statement emphasizes that identifying and quantifying environmental
risk should be part of the normal process of risk assessment and management. It
supports the precautionary approach to environmental management.
The Statement promotes the development of products and services that will
actively promote environmental protection.
The Statement intends to promote environmental responsibility in the financial sector. The
Statement recognises the need that signatories conduct internal reviews and measure
their activities against their environmental goals. It promotes information sharing with
customers and other stakeholders; research; dialogue with other financial corporations
and sharing best practice with them; and work with UNEP to review their success in
implementing the Statement.
In addition to the two statement, the UNEP FI has three key working groups:
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 95
1. Climate Change: experts of banks and insurance companies join in this group to
assess the role finance can play in reducing greenhouse gas emissions, and
promoting renewable energy and inform policymakers on their findings.
2. Investment: this program aims to provide a platform for sustainability of
investments by e.g. institutional investors, especially in emerging markets. The
working group has also designed sustainability indicators for capital markets.
3. Environmental Sustainability Management and Reporting (SMR): this
program offers guidelines and a discussion forum for SMR, and collaborates with
the Global Reporting Initiative (see later in this chapter) on environmental
performance indicators for the financial sector.
Each working group:
includes 15 to 20 companies,
is chaired by one or two of the companies,
aims at exchanging views, developing common approaches and facilitating better
understanding of environmental trends and their implications for financial services
In addition, UNEP FI currently has two projects:
1. Finance and Conflict: this project attempts to analyse the role financial
companies have in sustaining conflicts, and consequently seeks to asses in what
ways financial enterprises can help promoting peace instead of conflict
4
.
2. Water: this project focuses on the role financial institutions could have in creating
water sustainability. It aims to assess potential risks and opportunities of
engagement in the water sector and water related domains.
Besides these thematical groups, the UNEP FI also has established five regional task
forces: Africa, Asia-Pacific, Latin America, North America and Central and Eastern
Europe. Those regional groups are supposed to work closely together with the general
working groups and projects.
Mostly through annual meetings, UNEP FI aims to stimulate discussions among
decision-makers and staff of financial firms around the world.
Critical issues
The UNEP Financial Initiative has some serious shortcomings. The statements
are not binding, and thus are no more than an expression of good intention. There
is no external verification mechanism of the implementation of the statement by
the signatory financial firms. According to observers, peer group pressure does
not take place as expected, which means that it is difficult to deal with the free
riders. Moreover, the commitments in the statement are not very far-reaching nor
strongly worded, which casts doubts about the meaningfulness and impact of the
statement
5
.
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 96
4.1.2 The EPI-Finance 2000 initiative to develop
environmental measurement indicators
In 1999 and 2000, 11 financial corporations with headquarters in Germany and
Switzerland developed indicators to measure the environmental performance of financial
firms.
The set of Environmental Performance Indicators for the financial industry (EPI-Finance
2000
6
) applied the new environmental performance evaluation standard of the
International Standards Organization (the so-called “ISO 14031”) 14031 as a guideline.
The EPI indicators are categorized by ‘Management Performance Indicators’ and
‘Operational Performance Indicators,’ and focus on primarily on direct environmental
effects of financial firm’s behaviour. The project did not consider ‘Environmental Condition
Indicators’ indicators that measure more indirect environmental impacts, for instance
associated with a project’s credit line. The financial firms developing the indicators
decided it is methodologically problematic to measure such environmental changes
because they see it as their client’s primary responsibility to document these changes.
7
The EPI-Finance 2000 proposes indicators covering four categories of financial services:
1. commercial banking,
2. investment banking (which here also covers project financing),
3. asset management,
4. insurance.
And indicators relating to:
integrating environmental issues into the core business, including operational activities,
development of environmental products and services for financing or insuring
environmental pioneers and innovations.
Because financial institutions rarely know their clients’ eco-balance, the guideline drafters
decided it was not possible in 2000 to develop universal indicators for environmentally
oriented products and services. Rather, each financial firm should define, for itself, an
environmental quality standard, which it is supposed to use to determine environmentally
oriented products and services.
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 97
The EPI-Finance 2000 report identified the environmental relevance of financial services
8
as described in the table below.
Table: The environmental relevance of financial services
Business sector Product and services with
particular environmental
relevance
Products and services with
less environmental relevance
Commercial Banking Corporate clients
Mortgage lending
Letter of credit
Guarantees
Lombard loan
Interbank business
Investment Banking Corporate Finance
Project Finance
Trade Finance
Trading
Asset Management Shares
Funds
Real estate (provided that it is
contained in “Assets under
Management”)
Money market
Interbank business
Insurance Corporate clients
(Environmental-) third party
liability
Life insurance
Source: EPI-Finance 2000, Environmental performance indicators for the financial industry.
4.1.3 WBCSD Working Group Finance
In 2001, the World Business Council on Sustainable Development (WBCSD) was
approached by a group of banks, insurance, and reinsurance companies and asked to
start a project on:
the impact of sustainable development on the financial industry,
the criteria on which a sustainability strategy for the financial industry should be
based.
Based on a series of stakeholder dialogues, the Financial Sector Project released a
position paper
9
in Johannesburg during the World Summit on Sustainable Development at
an event organized with the UNEP Finance Initiative (2 September 2002). The chairmen
of 11 financial firms that were member of the WBCSD Financial Sector Project:
argued that integrating sustainable development into their businesses is crucial for
continued success,
outlined the major issues from a business perspective, namely integrating sustainable
development into the core business and management systems as well as in relationships
with different stakeholders; promoting sustainable development issues with other
companies in the financial sector; creating innovative financial products and services that
promote a sustainable society,
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 98
recognised the influence and responsibility of financial companies as drivers for change
towards sustainable development in the sector, however it was noted that the limits of this
influence needed to be further explored,
encouraged the sector to be more transparent in its financial reporting.
4.1.4 UN ‘The Global Compact’ Financial Institutions’
Initiative
The UN Global Compact is a CSR initiative applicable to all business sectors, expressed
in 10 voluntary principles on human rights, labour rights, environment and anti-corruption.
The initiative was started by Kofi Annan, Secretary General of the UN, in an attempt to
integrate social and environmental issues in business practices.
In the beginning of 2004 financial institutions in particular were invited to join the initiative,
and in June of that year 18 financial institutions (among which banks, insurance
companies and asset managers) designed a set of recommendations and guidelines
especially directed to the financial sector, published in the report “Who cares who wins.
Connecting Financial Markets to a Changing World”.
10
In the report, the financial firms made recommendations to all sorts of financial market
participants, ranging from stock exchanges, pension funds, investors, financial advisors,
financial institutions and regulators. The main recommendations are:
Analysts, asset managers, brokers, investors and pension funds are
recommended to screen investments on Environmental, Social and Governance
(ESG) factors and urge companies to pay more attention to these issues.
Financial institutions are recommended to include these ESG indicators more
systematically in their research and investment decisions.
Companies should themselves also pay more attention to these issues in their
business activities.
Consultants and financial advisors are recommended to create more demand for
research on ESG performance, and work on improvement of reporting on those
issues.
Regulators should provide a clear, predictable regulatory framework. A minimum
degree of disclosure on ESG issues is necessary to improve the financial
analysis. Stock exchanges are recommended to require listed companies to
disclose information on ESG issues.
Accountants should facilitate standardisation.
NGO’s can play a role in providing the public and financial sector with objective
information on companies’ performance.
4.1.5 Wolfsberg principles
The Wolfsberg Principles
11
are a set of guidelines to combat money-laundering activities.
The guidelines were designed and endorsed by a group of 12 commercial banks, the
“Wolfsberg group”, called after a gathering at the Swiss Chateau Wolfsberg in 2000.
Members of the Wolfsberg group are: ABN Amro, Santander Central Hispano, Bank of
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 99
Tokyo-Mitsubishi, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs,
HSBC, JP Morgan Chase, Société Générale and UBS.
The group has developed the following statements and guidelines:
Wolfsberg Anti-Money Laundering Principles for Private Banking (published in
October 2000, and revised in 2002). These principles state that banks will only
accept money of clients “whose source of wealth and funds can be reasonably
established to be legitimate”.
12
Statement on the Suppression of the Financing of Terrorism (January 2002).
Since not all funds to finance terrorism derive from criminal activity, regular Anti-
money laundering policies do not suffice to mitigate terrorism. The banks’ state
that they want to work with governments to prevent financial services to terrorist
groups, detect suspected terrorist financing, and share information with
government entities.
Wolfsberg Anti-Money Laundering Principles for Correspondent Banking
(November 2002). Corresponding banking refers to the services offered by a
domestic banks, e.g. a bank account, to foreign institutions. For example, the
Principles state more attention is to be paid to the correspondent banking client’s
domicile, ownership and management structures and business and customer
base.
Statement on Monitoring, Screening and Searching (published in September
2003). In this document, the Wolfsberg Group aims to identify means to
adequately monitor, screen and search financing of terrorist and other criminal
activities.
4.1.6 The Collevecchio Declaration by NGOs
A group of NGOs concerned with the damaging environmental and social results of
projects financed by banks and other financial firms drew up new guidelines and principles
for the financial sector.
The Collevecchio Declaration on Financial Institutions and Sustainability constitutes the
most comprehensive set of guidelines of the CSR initiatives up to 2003. The declaration
outlines civil society's expectations from the financial sector to advance sustainability.
These expectations go far beyond current practice and are radically different from the
financial industry’s current thinking, practice and CSR initiatives. The Declaration aims for
real improvements on the impact financial services activities have on societies and
environment.
The declaration was released
13
in January 2003 and was endorsed by over 100 civil
society groups by the beginning 2004.
The Collevecchio Declaration states the six key guiding principles NGOs are calling on
banks and other financial firms to adopt. It also outlines the immediate steps necessary to
implement the principles. NGOs expect financial firms to adhere to these six major
principles, throughout all levels of their activities and transactions.
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 100
Principle 1.
Commitment to sustainability at the level of core business
Steps to be taken immediately
Measure environmental and social impacts of the financial firm's range of activities
including lending, investing, underwriting and advising.
Strive to continuously improve management and evaluation systems related to
environmental and social impacts of the activities financial firms finance.
Foster sustainability operations and products, transfer financial support away from
damaging activities to sustainable alternatives (e.g. renewable energy rather than
pipelines projects), and advocate sustainable practice within the wider financial industry.
Implement sustainability objectives and capacity building with and for staff.
Principle 2.
Commitment to adopt the precautionary principle and ‘Do No Harm’ approach
Steps to be taken immediately
Use sustainability procedures including project screens, which asses impacts at the
environmental and social levels.
Adopt internationally recognised sustainability standards relevant to the project or
company to which financial services are provided (e.g. Forest Stewardship Council
standards).
Principle 3.
Commitment to responsibility
Steps to be taken immediately
Bear full responsibility for the impacts of transactions and risks taken.
Recognise financial firms' role in developing country debt crises.
Principle 4.
Commitment to accountability to their stakeholders
Steps to be taken immediately
Engage in public consultation with the aim of taking the views of the stakeholders,
especially those affected by financial services, including when they say NO to a
transaction.
Support rules on stakeholder rights.
Principle 5.
Commitment to transparency
Steps to be taken immediately
Issue annual corporate sustainability reports with information pertaining to all levels of
business including sub-sectors and subsidiaries.
Disclose information on completed or pipeline transactions.
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 101
Principle 6.
Commitment to Sustainable Markets and Governance
Steps to be taken immediately
Recognise and support the government’s role in policy and regulation.
Discourage inappropriate financial practices such as use of tax havens and currency
speculation whilst encouraging decisions based on longer-term time horizons.
The Collevecchio Declaration is being by used as a base for NGOs to assess and make
recommendations for other declarations, codes and CRS initiatives currently being put
forward by the financial industry (see below: Equator principles, reporting initiatives).
NGOs working with the Declaration meet regularly to update, develop and coordinate their
work under the umbrella named “BankTrack”.
14
NGOs are aware that not all improvements can come from the financial industry itself.
The Collevecchio Declaration (see principle 6) calls on the financial industry to support
regulatory changes that make it possible for the sector as whole, to advance sustainability.
This call warns against lobbying of the financial industry against governmental social and
environmental regulations for the financial industry, which could undermine CSR
initiatives.
Friends of the Earth-US issued recommendations aimed at improving regulation and
public policy.
15
4.1.7 Further developments and critical issues
Various CSR initiatives covering all financial services refer to continuous development
and changes of guidelines, and the need to improve transparency. Yet, most fail to call
for external verification.
So far, many initiatives focus on the environmental aspects of sustainability and corporate
social responsibility with less attention to social, labour and human aspects. While the
labour conditions in European banks might be fine, in developing countries, this is not
always the case even at branches of Western banks, as was revealed in case studies
researched by Observatório Social in Brazil
16
and Business Watch Indonesia
17
. Gender
issues should also be part of the corporate social responsibility because of the domination
of women employees at the lower job level and domination of men and masculine culture
at the (top) management levels.
The problems surrounding financial firms disclosing information on the implementation
of CRS initiatives has been the focus of many NGOs campaigns. Many banks refuse to
release information arguing client confidentiality and business competitiveness. However,
some ethical banks and even the Bank of Scotland release fairly extensive lists of projects
and clients, which shows that more transparency is possible.
18
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 102
4.2 CSR aspects in retail and corporate banking
Banks' lending services to individuals, governments and companies have lead to many
civil society actions directed at particular banks
19
as well as the wider industry.
4.2.1 Project financing
Project financing is the target of many CSR initiatives. Projects that are considered ‘high
risk’ are precisely those where CSR problems are most likely to occur.
Risky project areas:
financing projects that harm tropical rainforests e.g. palm oil plantations,
financing mining operations,
financing oil and gas operations,
financing trade in 'blood diamonds' originating from rebels in conflict areas,
financing investments in countries that gravely violate Human Rights (e.g. Burma)
NGOs have undertaking campaigns against financial firms for their role in financing such
risky projects. In response, some financial firms have developed sector specific guidelines
for project financing. For example, ABN Amro developed the “ABN Amro Risk Policies on
Forestry and Tree Plantations". However independent, external verification of the
implementation of these guidelines is still not in place.
Various groups of NGOs are involved in developing environmental and social standards
for projects including dam and mining projects. They promote these standards at
international governmental sector forums such as the Forest Investment Forum and the
World Commission on Dams. These same standards should be used by the financial
industry in their risk assessments before financing these types of projects
20
and before
providing financial services to corporations in the related sectors. Project financing is a
small part of the activities of many large banks.
4.2.2 Equator Principles by banks
The Equator Principles
21
are a set of voluntary commitments, designed by a group of
banks, which are similar to those environmental and social safeguard policies already
being used by the International Finance Corporation (IFC), the private financing arm of the
World Bank.
The IFC convened a meeting of banks in London in October 2002 to discuss
environmental and social issues in project finance. At the meeting ABN Amro, Barclays,
Citigroup and Deutsche Bank decided to develop a banking industry framework to be used
to assess environmental and social risks in project financing. This led to the drafting of the
Equator Principles, which uses the IFC standards as a basis in lending procedures for big
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 103
projects. Banks do not actually sign a statement. Instead, they ‘adopt’ the text and
promise to implement the framework in their organization.
By adopting the Equator Principles, the banks state that they will only provide loans
directly to projects if they have fulfilled certain conditions. Some conditions are:
Based on the safeguards of the IFC, the bank identifies the risk category of a
project: A, B and C. Categories A projects involve very risky projects, projects in
category B are less risky, and in category C projects, the risks are minimal or to
be neglected;
For all Category A and Category B projects, the banks have to complete an
Environmental Assessment (EA). The preparation of the EA is supposed to be
consistent with the outcome of the categorisation process and satisfactorily
address key environmental and social issues that have been identified during the
categorisation process;
For all category A projects, and for category B projects if applicable, borrowers
have to have prepared an ‘Environmental Management Plan’ (EMP) which draws
on the conclusions of the EA. It includes plans for mitigation, monitoring,
management of risk, and schedules.
If necessary, an independent environmental will be appointed for additional
monitoring and reporting;
Finally, the principles only apply to projects over $ 50 million dollar. According to
the Equator banks website
22
, projects below this threshold represent only 3% of
the total project finance market.
The banks that endorsed the Equator Principles in June 2003 were mostly those banks
which had been under pressure by civil society actions. The first 18 banks that signed the
Principles covered 74%, or $ 43 bn, of all project financing loans. In 2004, the Principles
are predicted by legal experts to become the prevailing standard for addressing social and
environmental issues in project finance transactions.
23
In the beginning of 2005, 28 banks
had endorsed the Principles.
Critical issues
No further steps?
Some banks confided with NGOs that in reality it is difficult to take further steps if
other banks do not also apply those principles. However, Citigroup agreed
beginning 2004 to implement higher environmental standards, for example,
related to endangered ecosystems and zones with social fragility, illegal logging,
climate change and renewable energy. Rainforest Action Network called
Citigroup's move the strongest articulated environmental policy of any private
financial institution.
24
Downgrading the IFC standards?
Just when the Equator Principles were finalized
25
(April 2003), the IFC
Ombudsman identified various implementation problems with IFC’s environmental
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 104
and social safeguards. As a result, the IFC started an overall review of its
environmental and social safeguard policies and standards in 2004. NGOs
monitoring the process fear that the financial industry, which has been asked to
provide input, will push to weaken IFC policies. IFC is aiming to change its
principles ‘performance standards’ instead of ‘safeguard policies’. This could be
problematic, because then banks can will only try to satisfy the listed standards,
instead of actually trying to warrant the interests of stakeholders. If the IFC
standards will be weakened, this would also endanger the Equator Principles,
since they are the standards on which the Equator principles are based.
What difference in practice?
To date, it is not clear whether using these principles make a difference in practice
when banks screen new projects. Due to fierce international competition, banks
decide quickly about buying into a syndicated loan project. The extra times it
takes to assess sustainability aspects might result in competing banks stepping
into the lucrative project (although, if all banks adopted and abided by the
principles, they all must make the additional assessments).
Already during the early stage of implementation (January 2004) NGOs have
begun to question whether those banks, which signed up to the Equator
Principles even use them.
The principles seem not to prevent banks from financing the same kind of projects
that in the past have proven to be environmentally destructive.
26
Five projects have already been identified where signatories of the Principles are
financing
27
highly problematic projects, which violated IFC policies. The
controversial projects include the Baku Tbilisi Ceyhan pipeline
28
(ABN Amro is
coordinator of the syndicated loan) and the Camisea gas pipeline in Peru.
29
And for those projects that are ‘assessed’ using the Equator Principles, NGOs
have no way of verifying whether and how the banks actually implement the
procedures. Do they use models? Checklists? As there is no disclosure
mechanism, there is no way of verifying, at this point, how the principles are
implemented.
4.2.3 Beyond the Equator Principles
NGOs in BankTrack said that despite the problems, the Equator principles are an
important first step in reforming project finance.
In their first comment on the Equator Principles
30
(June 2003) BankTrack outlined
outstanding critical issues in the CSR debate:
1. No-go areas: The “Do no harm” principle in the Collevecchio Declaration calls for
an explicit commitment to categorical prohibitions for the most socially and
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 105
environmentally egregious transactions. The Declaration also emphasizes a
precautionary-based approach rather than one based on mitigation.
2. Scope of applicability and effectiveness—too limited: NGOs recognise the
limitations of the current CSR initiatives in the financial sector as they mostly
apply to project finance only, and only pertain to direct loans. Banks should
review the environmental and social impacts of different segments of their
activities and develop appropriate policies. For example, mining and forestry are
often very sensitive sectors but are not commonly financed by project financing
and syndicated loans but for instance through open account credit to mining or
forest companies.
3. Lack of accountability and transparency: There is no mechanism for ensuring that
endorsing banks actually implement CSR standards. Banks refer to their
commercial interest to retain “bank secrecy” and refuse to provide civil society
organisations with insight in which projects they are financing or which companies
they financially support. It would be relatively easy for banks to disclose all of their
investments and projects, so that NGOs can independently monitor and scrutinize
projects. The lack of transparency requirements prevents endorsing banks to use
peer pressure and prevents the public to monitor implementation of CSR.
4. Weak on social issues: the standards of the International Finance Corporation
(IFC) are, compared with those of the World Bank, relatively weak on social
issues, and the Equator Principles reflect this weakness. For example the late
January 2003 version of the Equator Principles referenced “human rights,” but
was replaced by “socially responsible” in subsequent versions.
5. IFC standards are not best practice: NGOs hope that the adoption of the Equator
Principles will not delay the adoption of best practice sector standards such as
the World Commission on Dams guidelines, the forests policies proposed by
WWF-Friends of the Earth
31
, and the categorical prohibitions used by some
export credit agencies such as the U.S. Overseas Private Investment
Corporation.
6. Recourse and responsibility: The Principles put most of the responsibility on the
borrower, and there is currently no mechanism for affected communities to have
recourse to the bank in cases where standards are not being met or
implemented. In contrast, the IFC itself has a Compliance Advisor Ombudsman,
which investigates complaints from affected communities affected on alleged non-
compliance with IFC’s own policies.
Due to the many concerns about the implementation of the Equator Principles, in January
2004 BankTrack put forward a detailed statement
32
on precisely how banks should
implement the Equator Principles (EP).
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 106
Five sets of recommendations on how to implement and expand the Principles are related
to:
The full integration and implementation of the EP in the banks' operation,
including making themselves assessments of the social and environmental
impacts.
Integration of the EP in the banks' relations and agreements with borrowers.
Commitment to transparency and external verification.
Commitment to independent accountability mechanisms.
Commitment to move beyond the current scope of the principles and meet best
practices.
Ideally, other institutions including rating agencies, institutional investors and pension
funds, should use the Equator Principles when they have to assess a bank or other
financial firms.
4.2.4 Integration of environmental and social aspects in
regular corporate financing
Most banks take no consideration for social and environmental factors when providing
loans and financial services. Environmental factors are mostly only taken into account if
they affect the client's credit-worthiness.
33
If the client takes environmental risks, like
damaging the soil through the production processes, the bank might be affected. In this
scenario, the property, which is used as collateral is being partially or wholly devalued if
the production process damages the environment. Moreover, an environmental scandal
can affect the bank's reputation.
Some retail and corporate banks have begun taking a pro-active approach to promote
sustainability by offering environmentally oriented products such as 'eco-loans' that
provide favourable conditions for environmental pioneering or innovating projects.
4.2.5 Retail banking
Some ethical banks have special saving products that promote sustainable development.
For instance, clients can let the interest paid on their savings account be transferred to
environmental or development NGOs.
Until now, in CSR debates, little attention has been paid to the social role banks perform in
society, and as a consequence their responsibilities in providing services to a broader
public.
There do exist some good initiatives of banks that acknowledge their social role, and have
as a consequence taken steps to improve access to credit:
Some banks have committed themselves to keeping branches open outside of
urban areas, to support to the elderly and the rural population.
34
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 107
The importance promotion of credits to SME’s has also been identified and
followed up by some important institutions. For example, the European Bank for
Reconstruction and Development (EBRD) has a special program to stimulate
finance to SME’s in East European countries.
35
Increasingly, some mainstream banks have set up micro-financing activities . For
example, ABN Amro did so in Brazil in 2003 and Citigroup financially supports
micro-credit schemes in Indonesia. With micro-credit, small entrepreneurs are
provided with very small credits, which is generally believed to be a very good
mechanism to combat poverty. The UN have designated 2005 the “International
Year of Microcredit”, a project coordinated by the United Nations Capital
Development Fund (UNCDF) and the United Nations Department of Economic
and Social Affairs (UNDRSA). The project is sponsored by Citigroup, ING Group
and Visa.
36
4.2.6 Alternatives
Even thought banks have paid increased attention to CSR issues, too often these
initiatives are used as mere Public Relations and charity, and are not considered as
banks’ core credit activities. Some civil society groups have therefore developed ideas on
ways to arrange credits, without reliance on the commercial banking sector. The credit
unions already present in many countries, are an example of such an alternative to
commercial banks. Some NGO’s have proposed more far-reaching systems. For example,
the Strohalm Foundation stimulates the use of Local Exchange Trading Systems (LETS)
in which small companies and consumers cooperate. The profit of such systems is that
people are less dependant on a bank, and that there they don’t have to pay any interest.
37
4.3 Asset management and socially responsible
investment
Different financial service providers are involved in asset management:
Banks and investment firms assist corporations, wealthy individuals and
institutional investors by managing their capital and other assets to get the
highest rate of return.
Insurance companies manage assets in order to have enough financial reserves
to service potential insurance claims.
Pension fund managers invest to increase their capital to guarantee payment to
pensioners who paid contributions.
Mutual funds invest in company shares to increase the value of their funds and
provide high returns to their clients.
An important part of asset management (managing money) is buying equities that are
expected to earn high returns in the short or long term. These investments allow
companies listed on the stock market to operate and expand their activities.
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 108
4.3.1 Investing in companies - socially responsible
investment (SRI)
Asset managers have traditionally only focus on high returns when they select a company
to invest in. Rarely, if ever, did they use criteria beyond those which assess the financial
viability and profitability of companies. Their investments could, and do, support
companies whose activities are exploitative, destroy the environment and violate human
rights.
Due to many actions, discussions and initiatives by civil society groups and trade unions
there has been increased pressure asset managing institutions, including pension and
mutual funds, to review the corporate social responsibility of companies in which they
invest and withdraw their capital from companies which violate human rights and destroy
the environment.
Different strategies can be used to screen companies on social and environmental
criteria
38
:
Exclusion mechanism: certain sectors/companies will simply be excluded from the
investment portfolio (e.g. nuclear energy, weapon industry, tobacco,
pornography);
Targeted investments: investments will be specifically directed towards
sectors/companies/projects that have a social value added (e.g. education,
recycling, healthcare, renewable energy);
Best-of-class approach: investments will be directed towards companies that are
performing well on social and environmental issues compared to other companies
in the same sector;
Engagement: investors will use their shareholder power to engage companies
into better social and environmental policies.
As a consequence to this increased attention to socially responsible investments, a large
industry has evolved around the research of and ranking of companies on SRI grounds.
Since research on environmental and social performance can be costly for individual
investors, these firms make it easier for asset managers, institutional investors a means to
include these indicators in their choice of investments.
Research institutes include SiRi company, an international network of private research
organizations. These institutes often also establish rankings of companies.
Other SRI research include ‘sustainability rankings’ like the Dow Jones Sustainability
Indexes
39
(e.g. the Dow Jones Sustainability World Index) and the FTSE4Good Index
Series
40
.
SiRi
The Sustainable Investment Research International Group, (SiRi) is an umbrella
organization for private research organizations in different countries, which supply
information to the largest asset managers, insurance companies, pension funds, banks
and social investment institutions of the world.
41
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 109
The member organisation of SiRi in the Netherlands is the 'Dutch Sustainability Research
BV' created by Triodos Bank, PGGM (pension fund), and MeesPierson (a private banking
branch of Fortis). It cooperates with Triodos Advisory Services BV.
The SiRi database contains profiles of 600 large international companies and 4 000
other companies worldwide.
42
SiRi claims that each profile contains over 350 data
points and analysis, and "that all major stakeholder issues are covered including
community involvement, environmental impact, employment relations, customer policies,
human rights issues and corporate governance.” For each issue, SiRi describes and
analyses the company's policies, management systems, reporting standards and impacts
together with particular strengths and weaknesses. In addition, SiRi Global Profiles
contain information on controversial business practices such as armaments, tobacco,
animal testing or GMOs. "These profiles allow comparison between companies, sectors
and markets over the whole range of socially responsible investment issues of concern to
professional investors."
43
4.3.2 Mutual funds and ethical funds: is there a difference?
To date, SRI information is not often used by mainstream investment and mutual funds
managers. Instead, this information is especially used by “ethical funds” that buy up
shares from companies that are screened for their records on environmental and social
responsibility.
Either by using external research, or their own, ethical funds in Anglo-Saxon countries
tend to exclude weapons and tobacco companies immediately. European ones tend to
seek out companies that play an innovative role on providing a substantial contribution to
corporate responsibility or sustainable development.
SiRi's overview
44
showed that as of June 2004, there were 354 European green, social
and ethical funds, or 13% more than in the 12 months prior. SRI assets dropped by 16%
from €14.4 billion at the end of 2001 to €12.2 billion at the end of the second quarter 2003.
In 2004, assets under management accounted for €19 billion.
The shares of companies that are most often included in European green, social and
ethical funds are Vodafone, Pfizer, Johnson & Johnson, Citigroup, GlaxoSmithKline,
Microsoft, Royal Dutch Petroleum (Shell), Astrazeneca, BP and Nokia. However, several
of these companies have been the target of civil society initiatives due to their
irresponsible and destructive activities. Ethical, social or green funds seem to often
include companies which are subject to NGO protests.
45
For instance, the 'ING Bank
Duurzaam Rendement Fonds' includes Royal Dutch Petroleum (Shell), American Express,
Bank of America, Johnson and Johnson, BP, McGraw-Hill Companies, Suncor Energy,
Medtronic, Bristol Myers Squib, Societé Générale. Independent research has criticized
ING’s investment criteria.
46
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 110
Critical issues
No official mechanism exist to decide whether it is appropriate for SRI to include
transnational corporations as ‘ethical’ whose activities to date are known to cause
social and environmental destruction while thwarting corporate social
responsibilities.
SRI research institutes, to date, only focus on large companies listed on the Stock
Exchange. Do ethical fund managers have the capacity to identify small
sustainable companies that are not listed on the stock exchange? More analysis
should assess the difference of selection between ethical funds from large banks
and those funds from alternative banks such as Triodos Bank.
4.3.3 UN norms for responsible investments for institutional
investors
In the context of UNEP FI’s asset management working group, in 2004 UNEP FI
announced their "Responsible Investment Initiative", as part of UN’s Global Compact
Initiative. In 2005, the UN will convene a group of leading institutional investors to draft a
set of Investment Principles, while a group of experts will provide advice. In 2006, the
plan is to build support and capacity from within the investor and policy-making
communities globally.
4.3.4 Pension fund management
Institutional investors and especially pension funds wield huge amounts of weight on the
capital and investment markets.
Civil society
47
, church groups and some trade unions increasingly have been pressuring
pension funds to invest in companies with high CSR standards, or in ethical and green
investment funds. In the UK, investment in SRI assets went from zero in 1997 to £ 80 bn
in 2001.
48
A 2003 report on the 250 largest UK occupational pension funds showed that
90% included social and environmental considerations in their Statement of Investment
Principles, however only 11% of the funds included either screening, a preference
approach or both in their socially responsible investment policies.
49
In the Netherlands,
still only 1% of total assets is directed to SRI portfolios.
50
One of main problems with pension funds is that the people who pay the contributions
(employees) and the people who receive the payments (pensioners) have no information
about how their pension is invested nor do they have any say in the matter. Banks and
other financial advisory companies have much more say in the management of the
pension funds’ assets. In other words there was, and still is, little stakeholder participation.
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Another problem is that governmental regulation is focused on guaranteeing future
payments to all pensioners who paid contributions, not on ethical criteria. Such
governmental regulations can even undermine efforts to use ethical criteria. Pension funds
that withdraw their shares from exploitative companies might loose highly profitable
shares that help to meet the requested income for the future.
Critical issues
There is now a fierce debate by governments and firms that offer pension
insurance on how income to pensioners can be guaranteed. The right to a
pension is under threat because accumulated savings decrease in value due to
market downturns and mismanagement of private pension funds which has
shrunk the needed reserves. Because of this financial trouble of pension funds,
equity considerations and ethical and environmental criteria get even more in the
margin. Will Western pension rights prevail over progress towards sustainable
development?
4.4 Insurance and Corporate Social Responsibility
Insurance allows individuals and companies to undertake activities by providing financial
and other support in case of loss and damage. It allows individuals to rebuild their lives
after theft, fire and health problems and enable companies to engage in risky business
(i.e. transport) or pay for employees who are ill.
From a corporate social responsibility perspective, the questions are:
Which individuals, companies and activities does an insurance company support
by providing its products?
What are the effects of its operations and its products on human rights, the
environment, labour, consumers and society at large?
How do insurance companies manage their funds?
Do the insurance products promote sustainable development?
4.4.1 Responsibility on social aspects not yet developed
In conducting this research SOMO has found little evidence of international initiatives
focusing on the social responsibility of the insurance industry except those related to asset
management (see above). The insurance industry business owns and manages a huge
amount of assets in order to pay for potential claims for insured clients. Equities (company
shares), bonds, property, real estate, art and other valuable items are examples of various
insurance company assets.
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Consumers’ rights, such as the right to be informed, are legislated in Western countries.
Insurance companies have broader social responsibilities however, related to human
rights, labour and consumers rights to access to basic services:
a. Universal access to basic services such as health insurance
Some basic principles of the International Covenant on Economic, Social and Cultural
Rights (CESCR) are non-discrimination and providing the highest standard of basic
needs. Private health insurance increases access to medical care and help reach the
highest possible standard of health care. On the other hand, private health insurance is
often only accessible to the rich. Companies offering private health insurance are
expanding in developing countries but some experiences such as in Kenya
51
show that
private health insurance companies focus on rich clients and deny poor clients their
services. If the rich opt for private health insurance, governments in developing countries
have less income to care for the remaining citizens who are mostly poor with no choice
but to stay with the government’s health care plan. This undermines the whole notion of
universal access and non-discrimination.
A socially responsible insurance strategy would mean adopting practices and activities
that avoid the exclusion of the poor and especially women, older people, disabled, ethnic
minorities and those in remote areas.
b. Labour
To date, there is little known about the working conditions of insurance employees, agents
and brokers in developing countries. It is also unknown whether employees are duly
informed when their insurance company is involved in mergers and acquisitions (see
OECD Guidelines, IV Art. 6).
There is no debate yet regarding whether insurance companies should assess a
company’s labour record prior to selling it insurance products.
c. Other ethical issues , as identified by the Global Reporting Initiative
52
(see 4.6)
Medical screening of clients and genetic testing: excluding clients based on their
medical record and sometimes genetic inheritance about which they have no
influence, undermines the very principle of insurance as a safety net for people
with unequal chances;
Transparent commissioning and handling of claims; in 2004-2005, the insurance
industry has been overshadowed by scandals whereby in the US it came to light
that many US insurance brokers and insurance companies were collectively
betraying customers by charging too high premiums. Insurance firms offered
brokers commissions that are only paid if the broker delivers a certain amount of
clients to the company. As a consequence brokers steered tenders so that clients
choose products from insurance companies giving the broker the highest
commissions.
Responsible marketing (best advice)
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4.4.2 Environmental issues in CSR initiatives
The increasing number of claims from a damaged environment and from disasters due to
erratic weather patterns has alarmed the insurance industry and forced it to accept that
they must incorporate environmental considerations into their policies.
Risk is always the starting point for insurance companies and ‘the environment’ is still
looked at in many different ways.
Some insurance companies recognise that damage to the environment can result in the
insured person or company having to stop operations, which is a risk of loss of income.
For the insurance company, this might result in loosing that person or company’s premium
or even in having to pay out a claim.
Other insurance companies recognise the role of their own activities in supporting
sustainable development.
Some insurers go further to promote sustainable development through interaction with
other economic actors of the insurance industry and consumers.
Some insurance companies are starting initiatives to manage and reduce the risk of
adverse impacts on the environment ("environmental risk"
53
) such as contamination of
land, negligent of bad management of waters or hazardous facilities, and emissions that
increase climate change. The criteria and measures they use are:
1. Attention to environmental risks in core activities including:
1. Risk management: techniques to calculate risk and price insurance products, which
include environmental risks factors such as the use of chemicals, the location of the
insured industry, community acceptance, the risk of pollution.
2. Prevention of loss and damage:
Measures of loss prevention as condition for insurance coverage.
Clients are required to use environmental risk control methods.
3. How insurance claims are handled.
4. Design of insurance products:
Contract terms and conditions, such as lower insurance premiums for
environmentally positive behaviour by the insurer (e.g. If the car covered
by the insurance travels a low number of kilometres).
Pricing of insurance contracts based on environmental risk management
of the insured companies rather than categories of companies.
5. Support for environmentally positive operations: for example, insurance for the wind
power generation business, insurance covering bicycle breakdowns and train
delays.
54
2. Environmentally friendly management of internal operations, including energy,
water and paper usage, responsible travel and properties; related issues include the
training of employees and communication practices and reporting on environmental data.
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3. Commitment to apply national and international environmental regulations.
On the other hand, some insurance companies provide insurance products for liability
arising from environmental damage such as pollution and compulsory clean up
operations.
55
This might encourage companies to continue to pollute even if they have to
pay an insurance policy fee.
4.4.3 UNEP Finance Initiative on insurance focuses on
environment
In 1995, various insurance, re-insurance companies and pension funds outlined a
"Statement of Environmental Commitment by the Insurance Industry"
56
By December
2003, the Statement was signed by 84 companies and 3 associations in 25 countries.
57
The signatories acknowledge the role they can play in managing and reducing
environmental risks and the skills their industry has to measure and respond to risks. On
the basis of this statement, the UNEP launched an Insurance Initiative to fund research
and organize awareness meetings and workshops.
In 2003 the initiative merged with the UNEP Financial Institutions Initiative, into the UNEP
Financial Initiative.
Similar to the UNEP Statement by Financial Institutions, insurance signatories want to
achieve sustainable development through the market within a regulatory framework and
accept the precautionary principle. They want governments to take the leadership in
defining and enforcing long term priorities “values”.
Through the statement, insurance companies commit themselves to pay attention to
environmental risks in their core activities. These activities include risk assessment of
potential clients, loss prevention, product design, claims handling and asset management.
Internal operations and property will be managed "in a manner, which reflect
environmental considerations". This is a weaker commitment than made by the Financial
Institutions on Environment and Sustainable Development.
The signatories promise to make periodic reviews of management practices and to
integrate changes in environmental management in core activities and in communication
with employees. They encourage researching creative solutions and claim to strive to
adopting best practices in environmental management within the industry and suppliers.
They promise to create measurable environmental goals and standards for undertaking
regular internal environmental reviews. Within the limits of “commercial confidence”,
relevant information will be shared with stakeholders.
4.4.4 Example of individual or branch CSR Initiatives
Besides the UNEP-FI insurance initiative, there is no major international CSR standard for
the insurance sector. Some individual insurance companies have been involved in smaller
initiatives. For example, some insurance companies are offering micro-insurance services
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in developing countries. The Dutch Interpolis, for example, cooperates with local
organizations in developing countries like Sri Lanka and the Philippines to establish
mutual micro-insurance schemes. These small organizations are stimulated to become
self-sufficient in the future, so that the local community can help itself within their own
social structure
58
. In addition, often national insurance branch organisations have
developed their terms of reference for CSR policy.
4.5 Investment banking
Investment bankers are intermediaries between the issuer of securities and the investor,
as well as advisors to the company issuing the securities. Only a few examples of CSR
initiatives in investment banking could be identified for this research report. There are
however many ways by which investment bankers have an effect on sustainable
development or could actively promote it. For instance, by screening the social and
environmental record of companies and governments before deciding to underwrite their
new securities. There are no clear signs that banks use CSR criteria in their decision to
underwrite or in the prospectuses they publish to inform future investors.
Investment banks can be affected by the bad social and environmental practices of their
clients. By underwriting, a bank assumes the risk of buying all the new securities from the
issuer and reselling them to the public. A bad reputation from social and environmental
damages caused by the issuer could reduce the value of the new securities, and thus
provide a risk to the underwriter.
4.5.1 CSR issues from the Global Reporting Initiative
The Financial Services Sector Supplement on Social Performance Indicators of the Global
Reporting Initiative (GRI) (see 4.6) have identified the following CSR issues of investment
banking:
Debt of developing countries
Investment bankers issue debt instruments such as bonds for developing
countries. This can help raise money for developing countries but can also
increase the debt burden by these countries as they have to repay the bond with
a set (high) interest rate at a certain date. If the issuing is done while the country
is already in financial problems, the repayment might easily become problematic
and lead to a difficult process with bondholders to reschedule or write off this
debt. This has been the case in many developing countries.
Financial support for projects, companies or governments with considerable
critical social or environmental behaviour.
By underwriting securities unselectively, investment banks may continue or
increase the malpractices implemented by their clients.
Bribery and corruption, e.g. in order to obtain investment banking contracts.
Control over corporate governance of recipients of investment bank services.
Number of poor country clients.
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 116
Innovative products that apply special ethical and sustainability criteria.
4.5.2 Issuing bonds from the World Bank
Investment banks operate not only as underwriters for bonds by developing country
governments but also for financial institutions like the World Bank. The World Bank gets
80% of its funds for loans to developing countries from the selling of its bonds. Most of the
World Bank bonds are bought by institutional investors such as pension funds. The latter
are confident that there is little or no risk that World Bank will not repay the bonds because
of the governmental backing and high rating (AAA) of the World Bank.
World Bank loans to governments, with the money raised from the bonds, have been
made conditional on major macro-economic restructuring programmes. Many civil society
groups see these programmes as increasing poverty and undermining sustainable
development. Civil society groups from Haiti, South Africa, Ecuador and Europe have
campaigned to boycott the buying of World Bank bonds. In response, many civil society
groups world wide are encouraging citizens to request their pension funds and other asset
managers not to buy World Bank bonds.
59
4.5.3 Emissions trading
The UN Framework Convention on Climate Change, through the Kyoto Protocol,
introduced international emissions trading, a market mechanism whereby countries buy
and sell their ‘right’ to pollute based on a credit scheme.
Financial firms are involved in emission trading in various ways, partly because there is
money to be made but several firms also intend to offer new products that hedge against
the risks of emissions particularly in the derivatives market.
60
4.6 Reporting initiatives by financial institutions
Reporting on the above described initiatives so far remains at the firm level (do financial
firms recycle, turn the lights off?) and at the level of monitoring management (did financial
firms develop the criteria and if so, how are they managing the implementation?). This is a
serious problem for assessing the concrete impact of corporate social responsibility and
accountability of a financial firm.
Most information is kept secret due to ‘client confidentiality’ and ‘competition,’ which
means CRS and sustainability results are underreported. With so little information,
external monitoring and verification is impossible.
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4.6.1 Social performance reporting through the GRI Financial
Services Sector Supplement
The Global Reporting Initiative (GRI) is a foundation that aims at offering companies a
framework for sustainability reporting. This set of guidelines is for voluntary use by
companies for reporting on the economic, environmental, and social dimensions of their
activities, products, and services. Companies of all different sectors are supposed to be
able to use the GRI guidelines. There is a central document for all sectors (“the
Guidelines”). Developed in a multi-stakeholder process, the general GRI guidelines intend
to be globally applicable with standardized reporting, which means comparing companies
will be possible.
In addition, GRI has developed “technical protocols” that help companies in implementing
the guidelines in practice. Finally, for some industry sectors GRI has developed specific
“sector supplements”. For the financial sector, a pilot version for a supplement for social
performance has been published in 2002.
In cooperation with UNEP-FI, GRI has also been working on a supplement for
environmental performance indicators for the financial services sector. This supplement
was published in March 2005 (see 4.6.2).
4.6.1.1 Social Performance indicators
The social performance indicators started as a pilot version
61
in 2002, and are ready to
use. They are based on an initiative already developed by a financial industry group, the
Social Performance Indicators initiative
62
(“SPI-Finance”).
The GRI Financial Services Sector Supplement on social performance contains
performance indicators as well as management performance indicators. The latter
describe the quality of engagement on corporate social responsibility (CSR Management).
The indicators are qualitative and quantitative, but take into account that quantitative
indicators will always need some qualitative interpretation.
The performance indicators for the financial services sector’s social impacts cover the
following areas:
1. Internal social performance, including relationships with staff's families.
Society in general, such as performance towards communities and countries in
which the business operates.
Impacts of products and services on clients, as well as on people who are
indirectly influenced by financial services.
The social performance of suppliers (towards their staff and society), as well as
performance of the financial firm towards those suppliers.
The management and operational performance indicators
63
for reporting are organized
under the following eight aspects:
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Management Systems: management of sensitive issues in all financial operations such as
bribery and corruption and anti-money laundering.
Internal Performance: human resources policies towards equal opportunities (banks are
well known for employing many women in the lower paid jobs and few at the top), stress
and ergonomics (SRI syndrome policy due to frequent use of computers), remuneration
for senior management, and for achieving CSR criteria.
Suppliers: screening of major suppliers for their social performance.
Society: the economic value created by a company's activities and its contribution to GNP.
Retail Banking: avoidance of social exclusion through access to financial services,
innovative products and financing to deprived communities; lending with considerable
social impact; marketing practices (e.g. of speculative of highly indebting products).
Investment Banking: issuing of debt instruments for developing countries and other
aspects of developing countries' debt; financial support projects with considerable critical
social impacts; bribery and corruption; control over corporate governance of recipients;
number of poor country clients; innovative products that apply special ethical and
sustainability criteria
Asset Management: responsible marketing and advice; screening of portfolios against
social criteria; innovative products that apply special ethical and sustainability criteria
Insurance: medical screening of clients and genetic testing; transparent commissioning;
level of access by women, old(er) people, disabled people, ethnic minorities, and people
living in geographically remote or disadvantaged areas; innovative products with special
social benefit that are not yet offered by the market.
4.6.1.2 NGO criticism
A group of environmental NGOs that published the Collevecchio Declaration criticised the
GRI's Financial Services Sector Supplement on social performance because it was not
based on an extensive and transparent multi-stakeholder process. Southern NGOs were
not heard during the development of the indicators whilst the indicators were determined
by the involved financial firms. The Supplement “focuses too much on internal corporate
responsibility aspects”
64
while the product and client side are far more important.
Financial corporations have the responsibility for the environmental and social impacts of
the activities they finance even if this entails indirect or complex financing operations.
Additional missing indicators in the GRI's Financial Services Sector Supplement on
social performance from the perspective of SOMO’s research includes:
The social impact of developing countries' indebtedness to private financial firms
or to holders of bonds or other debt instruments issued by banks;
The lobbying and political activities of financial firms against rules that promote
environmentally and socially progressive financial products and operations; or the
lobby against measures that limit developing countries' or poor people's
indebtedness;
The lobbying activities of financial firms to open up markets in developing
countries (e.g. in current GATS negotiations of the WTO) without a commitment
to increase the social and environmental benefits of such market opening;
Financial operations and products that contribute systematically to economic or
financial crises at the national and international levels with huge social
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consequences (job losses, etc.); examples are operations in speculative products,
quick moves out of a country for asset management purposes;
Providing services to clients to evade taxes such as presence in taxes havens,
which reduces governmental budgets to provide public social services;
The social impact of mergers, acquisitions and restructuring of companies, which
were advised and financed by private financial firms (mostly through investment
banking); at least investment banks could first evaluate if the companies involved
respect ILO Conventions and OECD guidelines for multinational enterprises
before offering their services (e.g. information to employees in due time before
mergers take place);
The link between social and environmental performance is absent
(environmentally damaging activities can have a direct social impact and vice
versa); the Supplement on social performance reporting indicators needs to be
integrated with environmental performance indicators (see below).
4.6.2 Environmental reporting indicators
4.6.2.1 Corporate initiatives
The set of environmental performance indicators for the overall financial industry
developed by the EPI-Finance 2000 project (see above) were primarily designed for
internal use and not for reporting, but they can serve as a basis for “external
communication”. The set calls, for instance, for concrete figures such as the number of
loans for projects that are environmentally pioneering or innovative. UNEP and the
WBCSD welcomed the set as a meaningful benchmark.
4.6.2.2 UNEP FI / GRI Initiative on environmental performance
Since September 2003, UNEP-FI and GRI have been building on the work completed in
the social arena, and worked to develop environmental performance indicators for GRI’s
financial sector supplement. A multi-stakeholder working group developed the indicators.
The working group had ten representatives from the financial industry, and ten
representatives of NGO’s and sustainability rating agencies. GRI and UNEP facilitated the
process.
The financial supplement for environmental performance emphasizes three indicators for
direct environmental impact about which financial firms should report (these were
already adopted in the GRI’s 2002 general Guidelines):
Total material use
Total waste by type and destination
Indirect green house gas emissions
In addition, the supplement presents thirteen indicators to report on a firm’s indirect
environmental impact, grouped in the following categories:
Policy: what policies does the firm apply to its core business lines?
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Systems and Processes: e.g. what processes are in place for assessing and
screening environmental risks in core business lines, for monitoring clients’
implementation and compliance with aspects raised in risk assessment processe.
Engagement: e.g. what interactions does the firm have with clients/business
partners?
Environmentally beneficial products and services: what is the total monetary value
of specific environmental products and services broken down according to the
core business line?
Activity statistics: value of portfolio for each core business broken down by
specific region and sector.
4.6.3 Reporting on sustainable credit activities by banks
The VBDO in the Netherlands has been assessing four major Dutch banks (Fortis, ABN
Amro, ING Group and Rabobank) by looking at sustainability and transparency aspects of
the banks’ credit activities (August 2003).
65
Some major conclusions of the research
report are:
1. Because there are no existing criteria among civil society and in national laws about
sustainable credit activities, banks have themselves to define sustainability and
develop criteria. In addition banks have to develop testing, measuring and reporting
methods to apply the sustainability criteria to credit activities.
2. Sustainability aspects are being taking into account by banks in their credit activities
only from a perspective of risks for the bank's reputation and risks of being
(financially) held responsible by society.
3. Reporting by the four Dutch banks in 2001 gave no clear or concrete information if
and how sustainability criteria are used in their credit activities; the very small
percentage of credits which were earmarked as sustainable (0.2% by ING, 0.4% by
Rabobank)
are striking.
4. Optimal instruments
66
to assess and monitor the sustainability of credits are difficult to
implement. Such instruments could for instance be:
i. a sustainability report of every credit, which can be obtained by the
public after request; or
ii. a sustainability certificate for each credit by the government or the
Central Bank.
One of the problems is the wish and need for confidentiality by the banking industry.
5. The two options for monitoring the sustainability of credits which seem to be feasible
and acceptable by the four researched banks are:
i. a management system that monitors how sustainability assessment
and testing of credits are being implemented, and
ii. external certification of such management systems.
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 121
6. The use by banks the GRI Sustainability Reporting Guidelines together with the
Financial Sector Supplements on social performance indicators and environmental
performance indicators would provide sufficient monitoring information, provided they
make available concrete information about criteria, indicators, monitoring methods
etc. with figures and percentages.
67
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 122
4.7 Conclusions and critical issues
1. Many possibilities, disappointing results
The initiatives of corporate social responsibility (CSR) indicate many areas where the
financial industry can:
a. avoid its negative social and environmental impact, and
b. support changes towards more sustainable societies through its core business.
In most of the financial services, these initiatives are not taken into account. For example,
the US$ 8,000bn mutual fund industry in the US invest hundreds of billions in securities of
companies without any screening for their social and environmental behaviour. In Europe,
ethical funds are only 0.36% of total assets managed on the continent and the companies
most listed in those ethical funds have often been subject to criticism for non-responsible
behaviour e.g. Shell, Citigroup.
Recent scandals at investment banks (conflicts of interest) and mutual funds
(unauthorised trading) which transferred huge illegitimate amounts of money to
management at the expense of the investing client, indicates that much still needs to be
done about basic ethical and decent behaviour in conducting the core business.
2. Wide range of CSR initiatives
At the international level, the financial industry has come up with different CSR statements
that have been signed by some of the top world banks and insurance companies. Some
are vague and general in wording, such as the CEO statement of the Business Financial
Sector Project of the World Business Council on Sustainable Development, while others
are more precise and to the point, such as the Equator Principles for project lending and
the GRI Financial Services Sector Supplement on social performance. In their
Collevecchio Declaration, NGOs go much beyond existing corporate initiatives and
request total commitment in all activities of financial firms. The Collevecchio Declaration is
the only worldwide CSR framework covering the full financial industry (although not much
about insurance) that can be used by civil society to screen private sector initiatives.
The kind of financial services that are best covered by CSR initiatives are project
financing, and asset management i.e. ethical investment by mutual funds and pension
funds. The insurance industry receives least attention from civil society while that
industry's asset management, pension insurance and insurance contracts can have a
major influence to stop unsustainable activities and support individuals and companies to
behave in a more sustainable manner.
3. Too little attention to social aspects
Social aspects, issues particular for developing countries such as Third World debt, as
well as supply chain responsibility are less covered by the CSR initiatives than
environmental aspects. References to respect of human rights and the core labour
standards of the ILO are lacking in many corporate CSR initiatives.
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 123
4. The financial industry does not allow for external assessment of CSR
initiatives
So far, it is impossible to assess whether the many CSR initiatives have made any
concrete improvement for society or have reversed environmental degradation, social
unrest or breaches of human rights. The existing CSR initiatives have not produced the
necessary external verification tools such information disclosure, impact assessments,
independent reporting, built-in continuous stakeholder accountability, etc. No tools are
offered to civil society to assess whether implementation takes place in practice or has
any real impact, and to address the financial industry to redress the problems it (helps)
create. Breaches of the Equator Principles revealed by NGOs and the free rider problems
of other CSR initiatives highlight the need of verification and redress tools.
A particular CSR problem for the financial industry is the lack of transparency argued on
the basis of bank secrecy, client confidentiality and protection of competitiveness. Much
more needs to be done than the current CSR initiatives that monitor and report only about
management. Options for more transparency in which governments and official
supervisors are involved, need to be explored. Without transparency there can be no
verification by stakeholders.
5. NGO cases reveal what needs to be changed
NGOs that have campaigned against banks involved in destructive project financing have
achieved some progress with major financial firms such as: the Equator principles that
were initiated by banks being put under campaign pressure; Citigroup's environmental
policy statement; sector policies at ABN Amro; Barclays refusal to participate in financing
the Caspian pipelines. More cases brought forward by civil society will help to reveal what
is needed and what needs to change. This is an on-going and fluid process.
6. Important dilemmas
The dilemma's facing NGOs that put pressure on financial firms to stop financing certain
projects, companies, governments of institutions are:
whether NGOs have enough power and capacity to pressure the financial
industry, one by one and collectively, in changing the negative effects of
all financial services, or whether they should seek alliance with other
stakeholders and/or the government.
whether financial firms should decide which corporations to finance, or
whether laws -supervised by the authorities- should set the criteria about
how the private financial industry should select the companies and
projects to be financed. The financial industry does not want to judge the
companies it financially supports (except for the potential financial risks
that undermines its profitability) and want to rely on regulations. On the
other hand, NGOs do not expect that governments will take sufficient
steps and expect more direct effects from undermining the financing of
destructive corporate activities.
Responsibility, of the financial firm and of the government, is clearly a
matter for debate and political attention. In 1999, the lobby of the
financial industry (the Institute of International Finance) was still of the
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 124
opinion that their only mandate was to make profit and increase
shareholder value, and that social and financial stability responsibilities
were for the government. Has this changed in practice?
7. Involvement of more stakeholders needed
NGO actions will also promote the much needed involvement of more customers, an
important segment of the stakeholders. According to research by the Dutch consumer
organisation (‘Consumentenbond’), the banks’ clients are not yet interested in CSR
principles
68
and better reporting from their banks.
CSR initiatives and reports might start drawing attention to the social and environmental
behaviour of the financial industry to another group of stakeholders: the financial firm’s
shareholders. Shareholder value needs to be looked at in ways other than simply ‘The
Bottom Line’ or ‘Share Price’. Shareholders need to know that ruthless profiteering is not
viable in the long term and that they have a choice about where they can invest their
money and earn their pensions.
8. Main elements for CSR initiatives and codes for the financial industry
What first needs to be addressed for further development of financial CSR initiatives is the
lack of a definition for sustainable development which is internationally recognised by
the financial sector and upon which screening, bench marking and reporting by the
financial industry can be based. This would allow for standards to be developed and
adopted that would make monitoring and comparison between the different financial
corporations possible.
Overall, CSR issues that are specific for the financial industry that should be included in
any CSR initiative are:
a. Transparency, verification and accountability tools.
b. The social and environmental aspects of the financial industry's own operations,
which should include respect of ILO, Human Rights and gender equality conventions
for own staff, sustainable energy use, training of staff on sustainability issues, etc.
c. Responsibility for the impact of their financial services regarding:
- Company and project financing: by using
existing overall international standards such as core ILO and Human
Rights conventions, OECD guidelines and CSR initiatives, and
International standards specific to the sector of the company or project to
be financed e.g. Forest Stewardship Council standards, standards of the
World Commission on Dams.
- Universal access, quality of services, discrimination or exclusion of poor
customers and small producers, and undue indebtness of poor customers and
poor countries: by using the Covenant of Economic, Social and Cultural Human
Rights.
- Macro-economic and financial instability:
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 125
the financial industry should limit its speculative products and services, short term
interest strategies in mutual funds, lack of commitment to support countries in
which they operate, lobbying for opening up financial sector markets while
adequate regulations are not in place.
- Other ethical issues:
lobbying against governmental rules that protect societal interests,
abuse of market power: see OECD Guidelines relating to competition
policy, transfer pricing and mergers,
abuse of unique market positions e.g. by investment banks or mutual
fund managers,
lax attitude towards money laundering and corruption,
support of tax evasion,
support of apartheid vs. support for black empowerment.
d. Pro-actively advancing sustainable development through:
the design of financial services (e.g. better financial terms for sustainable
behaviour),
choice of financing (e.g. renewable energy in stead of pipelines),
specific services to support the poor (beyond micro-financing), and
choice of strategies (e.g. reverse increasing consolidation and competition).
1
Information on UNEP-FI was taken from the UNEP-FI website: www.unepfi.org
2
This description was taken from: Summary of the UNEP FI 2003 Global Roundtable: Sustaining value -
A meeting on finance and sustainability: 20-21 October 2003, in Sustainable Developments, IISD,
Volume 91, nr 1, 23 October 2003 p. 1-2; for reports of UNEP-FI meetings and the different areas of
work, see: http://unepfi.net
3
See http://www.unepfi.org/signatories/statements/fi/index.html
4
See http://www.unepfi.org/work_programme/finance_and_conflict/index.html)
5
For NGO concerns on the UNEP-FI initiative, see www.banktrack.org
6
"EPI-Finance 2000": Indicators measuring the environmental performance of financial institutions, at
www.epifinance.com where the full report can be downloaded: Environmental performance indicators
for the financial industry.
7
Environmental performance indicators for the financial industry, p. 12.
8
The categorisation used in this table is not the one used in this SOMO report.
9
See http://www.wbcsd.org/DocRoot/5PV72pFXVXcIqJX88UlC/20020925_finance.pdf
10
See http://www.unglobalcompact.org/content/NewsDocs/WhoCaresWins.pdf
11
This description is taken from the Wolfsberg Principles website: www.wolfsberg-principles.com; Mark
Pieth & Gemma Aiolfi, The Private Sector becomes active: the Wolfsberg Process,
at: http://www.wolfsberg-principles.com/pdf/wolfsbergprocess.pdf
12
Wolfsberg Anti-Money laundering Principles on Private Banking, article 1.1, at www.wolfsberg-
principles.com
13
Environmental NGOs taking the initiative were amongst others: Friends of the Earth, Wilderness
Society World Wildlife Fund (WWF), Campagna per la Riforma della Banca Mondiale, Berne
Declaration and others
14
See www.banktrack.org
15
See www.banktrack.org; see also chapter 5, annex to the conclusions.
16
For a short insight, see www.somo.nl, and www.observatoriosocial.org.br
17
Full report to be published at the beginning of 2004 by BWI and SOMO
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 126
18
Bank Track, No U-turn allowed: NGO recommendations to the Equator banks, 23 January 2004.
19
See for instance actions against Citigroup, the largest financial services provider in the world, on
website of different NGOs and one particularly focussing at Citigroup (e.g.
http://www.ran.org/ran_campaigns/global_finance/)
20
See for instance www.banktrack.org
21
See http://www.equator-principles.com/principles.shtml
22
See http://www.equator-principles.com/faq.shtml
23
J. Sohn, NGO spotlight shifts to private sector, in Environmental Finance Magazine, February 2004.;
see www.equator-principles.com for details and figures.
24
Rainforest Action Network and Citigroup announce enhanced Citigroup environmental policy, press
release by Citigroup and Rainforest Action Network, 22 January 2004.
25
See: www.brettonwoodsproject.org/update/
26
At the SOMO workshop on CSR and the financial sector (The Hague, 19 November 2003), it was
revealed that during a conversation between NGOs and a bank that had adopted the Equator
Principles, the bank admitted that if current controversial projects would be screened using the Equator
Principles, the projects would be approved.
27
See Bank Track letter to the 'Equator Banks', Amsterdam 10 December 2003.
28
in Turkey, Azerbaijan and Georgia, see www.baku.org.uk; see Evaluation of compliance of the Baku
Tbilisi Ceyhan pipeline with the Equator Principles, October 2003.
29
See www.amazonwatch.org
30
See: www.banktrack.org which replaces the www.financeadvocacy.org website
J1
See: www.panda.org
J2
Bank Track, No U-turn allowed: NGO recommendations to the Equator banks, 23 January 2004.
JJ
This can for instance be seen from the indicators of the EPI-Finance 2000 report: Environmental
performance indicators for the financial industry, p. 24
34
For example, in the Netherlands a committee of commercial banks and consumer organisation is trying
to improve accessibility of financial services outside of urban areas, called “Maatschappelijk overleg
betalingsverkeer”, see Erica Verdegaal, Winkels, consumenten en banken kunnen niet zonder elkaar.
Knelpunten en oplossingen bankdiensten in kaart gebracht, in DNB Magazine, De Nederlandsche
Bank, no. 1, 2005
35
See EBRD website: www.ebrd.org
36
See the ‘international year of Microcredit’ website: http://www.yearofmicrocredit.org/
37
See http://www.strohalm.net/en/site.php
38
Based on a presentation of VBDO (Dutch Organization of Investors for Sustainable Development,
www.vbdo.nl) on SOMO workshop, January 13
th
, 2005, Amsterdam.
39
See http://www.sustainability-index.com/
40
See http://www.ftse.com/ftse4good/
41
More information at: www.siricompany.org
42
www.siricompany.com (There were more than 1000 profiles at the end of 2002)
43
www.sirigroup.org/services.shtml
44
Green, social and ethical funds in Europe 2004, SiRi Group - Avanzi, Milano, November 2004, at
http://www.ecodes.org/documentos/archivo/Fondos_Europa_2004.pdf
45
To assess the behaviour of these companies from a NGO CSR perspective, see for instance
www.transnationale.org
46
http://www.bijsluiterscore.info/P_INGBank_DuurzaamRendementFonds_028.htm
47
For example, the UK Just Pension’s; see: www.uksif.org
48
Ibid.
49
EIRIS, Responsible investment: EIRIS reveals SRI practices of top pension funds, press release, 19
May 2003.
50
Christel Witteveen, Groot geheim. Het beleggingsbeleid van pensioenfondsen, in People, Planet Profit,
Volume 3, no 2, Winter 2004/5
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 127
51
Challenges for the South in the WTO Negotiations on Services - Summaries and Conclusions from
Three Case Studies: Health Care (Kenya), Electricity (Colombia), Tourism (India), published by SOMO
and Wemos, January 2002 (see: www.somo.nl)
52
GRI, Financial Services Sector Supplement: social performance, November 2002, at
http://www.globalreporting.org/guidelines/sectors/GRIFinancialServices.pdf
53
See: Risk, the environment and the role fo the insurance industry, prepared by the UNEP FI
Australasian Advisory Committee on Insurance, EPA VICTORIA - UNEP Finance Initiatives, January
2003, p.5-7.
54
this insurance is developed in cooperation with BUND, the German section of Friends of the Earth:
Fourth International Conference of the UNEP Insurance Industry Initiative: Natural capital at risk -
sharing practical experiences from the insurance and investment industries. Executive summary report,
UNEP, September 1999, p.13.
55
See: Risk, the environment and the role of the insurance industry, prepared by the UNEP FI
Australasian Advisory Committee on Insurance, EPA VICTORIA - UNEP Finance Initiatives, January
2003, p.16-18, 32-36.
56
See http://www.unepfi.org/signatories/statements/index.html
57
See http://unepfi.net/iii/signatories_country.htm ; the figures relate to December 2003
58
See www.interpolis.nl; Interpolis, Micro-insurance in developing countries, at
http://www.mian.nl/docs/00355%20Micro-insurance.pdf
59
See for instance: http://econjustice.net/wbbb/
60
For more details, see CEO Briefing on emissions trading, January 2004, at http://unepfi.net
61
Non-final version but ready to use, test and provide feed back.
62
The SPI-Finance companies that were involved were: Co-operative Insurance, Credit Suisse
Group,Development Bank of Southern Africa, Deutsche Bank AG, Rabobank, Swiss Re, The Co-
operative Bank, UBS AG, Westpac Banking Corporation, Zürcher Kantonalbank, Interpolis, Rheinland
Versicherungen, Swiss Life, XL Winterthur International (see Social Performance Indicators for the
Financial Industry (SPI-Finance 2002))
6J
See annex: indicators of management performance relate to policies and activities, and operational
performance relate to results of policies and activities.
64
Letter (16 December 2002) to GRI by Berne Declaration, Campagna per la Riforma della Banca
Mondiale, Euronature, Friends of the Earth, Mineral Policy Institute, Rainforest Action Network, Power
Shift, Wilderness Society World Wildlife Fund United Kingdom.
65
R.F. Faber, Duurzame kredietverlening - Transparantie van duurzaamheid bij het rentmargebedrijf van
banken, VBDO Onderzoeksrapport, August 2003 (see www.vbdo.nl)
66
See: Ibidem, p. 7.
67
For full overview of the VBDO's recommendations on this issue, see: Ibidem, p. 11.
68
Consumentengids, December 2003.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 128
Chapter 5
Governmental regulations
at the international level
Introduction
The behaviour of the financial industry is influenced by regulations and implementation of
these regulations (supervision). Almost all binding rules and supervisory mechanisms are
still based at the national or EU level. However, many international institutions try to
influence national regulation and supervision even though their means of enforcement is
often limited to cooperation and peer pressure.
In the light of the growing trend towards internationally operating financial services
providers, this chapter identifies the major institutions at international level which deal with
the regulation and supervision of the behaviour of financial firms in the area of banking,
insurance and securities. Because it was beyond the scope of this report to analyse each
of the different national regulation and supervision systems, this chapter identified some
national trends worldwide.
In a second part, this chapter attempts to assess the impact of the consolidation of the
financial industry in relation to financial stability and the institutions that promote financial
stability.
In the following chapter 6, the international regulations about trade in financial services
under the WTO are analysed.
5.1 Trends of regulation and supervision at national levels
Many countries have systems to regulate and supervise banks, and other financial
services, in order to prevent that the risks taken by the financial industry would have
negative effects on society. However, regulation and supervision also have a decisive
influence on the development and structure of the financial services sector in each
country. This explains why the structure of the banking industries continues to differ
greatly across countries in the West, ranging from very non-concentrated banking in a few
countries (e.g. Germany) to highly concentrated in other countries (e.g. Australia, Belgium,
Canada, France, the Netherlands and Sweden).
1
National differences in regulation and supervision
The clear differences
2
that can still be observed in bank regulation and supervision in
various countries depend on:
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 129
(a) whether the national authorities follow a liberal approach and allow national
or international mergers and acquisitions of their banks (with differences in
preferring domestic banking consolidation or acquisitions of national banks by
foreign ones), or whether they want to stick to a more rigid and regulated
approach and restrict foreign or national take-overs. Banks in countries with the
latter approach are now assumed to have low levels of consolidation and to face
increasing international competition from larger financial corporations, resulting in
the challenge of being acquired by foreign financial corporations, or hardly play a
role of importance internationally.
(b) the attitude of the regulators in situations where banks are confronted with real
or emerging problems: authorities can adopt a proactive and strict approach,
whereby they set high standards of prudential control and take the tough
measures to resolve the problems at an early stage; or they can follow a passive
and/or soft approach (for political or cultural reasons). The latter approach is
typical for Japan, resulting in a continuing weak financial system with a huge
amount of bad loans, weak capital reserves, low profitability and demands for
government bailouts.
The significant regulatory differences between the EU and the US have lead to intensive
discussions. For instance, the European financial services industry fears that European
regulation tends to open up the market for US services while the US is having a
"regulatory revival" that harms the European financial industry.
3
This might lead to bilateral
informal discussions and solutions in which the rest of the world is not involved to make
their case.
4
Liberalisation trends in developing countries
In many developing countries, regulation has changed from hands-on regulation to more
indirect regulation. Governmental fixing of interest rates and control over allocation of
credit is seen as the cause of inefficiency, unfair lending and services, and low interest
rates that encouraged capital flight. Under pressure from the World Bank, the IMF and the
international liberalisation paradigm, controls on interest rates were relaxed, restrictions
on capital flows and foreign financial service providers removed, the banking system
restructured and given more capital.
5
At the same time, a financial "safety net" was
promoted by which each country would have prudential regulation and supervision, a
lender of last resort and deposit insurance. As could be seen in the case study of
Indonesia (chapter 3), deregulation was not always accompanied by good supervision and
regulation, and was undermined by corruption. Even if good standards of regulation and
supervision are in place, many developing countries have been struggling with lack of
qualifications, sufficiently equipped personnel, and support by the legal system.
6
Difficulties in supervision
Supervisors and regulators still do not have everything under control. This is shown
amongst others by the credit card crisis in South Korea since the end of 2003. Too much
unpaid credit was leading to the collapse of the main credit card company, which could
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 130
have severe consequences for the South Korean banking system and the economy. The
government was intervening, thus abandoning the principle that private banking should be
left to the markets even if they fail.
7
In different countries, including the US and Australia,
supervisors are struggling with scandals of illegal, unfair or too risky practices by financial
firms or some of their staff members.
Following (!) increasing consolidation of financial firms, some countries have reformed
their supervision and are bringing the different financial industry sectors -banking,
insurance, securities- under one supervisory institution or umbrella. This process is at
different stages in many countries. For instance, Italy just started to discuss such a reform
after the Parmalat scandal at the end of 2003. The challenge in such reforms is that such
reforms do not get politicised and lead to battles between different authorities wanting to
keep supervision.
8
International competition undermines national regulation and tax income
Also, international fierce competition can make it difficult for regulators to create prudential
laws or laws that protect consumers (e.g. obligation to lend to poorer buyers of houses).
They will often be threatened by arguments from the national and foreign financial industry
that new regulations will make the country and its financial industry uncompetitive
compared to the financial industry based in other countries. For instance, when banks
were closing rural branches in the Netherlands it was difficult for the government to
legislate them to remain open. In the worst case, banks threaten to withdraw their
operations from a country where they see legislation as undermining their profits.
International competition also explains the existence of offshore centres since some
governments want to promote their financial industry and their financial markets. Offshore
centres
9
are mostly small islands, such as the Cayman Islands, and small countries, such
as Singapore. They offer bank secrecy, low taxes or tax exemptions for foreign capital.
These offshore centres attract untaxed capital flows from other countries and are
suspected of money laundering and transfer criminal money. Most internationally
operating financial firms and accountancy firms have branches and services at, and
related to, offshore centres; this provides an income for these industries and the offshore
authorities. The US banking industry is the biggest user of offshore centres, especially the
Cayman Islands and Jersey.
10
Being put under pressure by international bodies and the EU, offshore centres' authorities
are formally improving their handling of money laundering and money deposits from
dictators while compulsory/binding measures at international level are still lacking.
11
Critical issues
Many national supervisory and regulatory regimes are not yet ready to cope with
increasing international competition and consolidation in the financial industry.
This competition and consolidation can have a chilling effect on national efforts to
appropriately regulate and protect consumers and poorer banking clients. This
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 131
could explain why national regulators are not intervening sufficiently to deal with
the many critical issues and problems explained in the previous chapters.
The few initiatives that exist to specifically encourage financing services and
financial firms to reduce poverty and promote sustainable development mostly
exist at national and EU level, not at international level. Examples are:
Tax free green funds: mutual funds exempt from interest and dividend
income tax e.g. in the Netherlands where green funds have been growing
faster than in other countries.
Disclosing ethical investment policies: laws requiring pension funds to
disclose their ethical investment policies and practices, as was
introduced in the United Kingdom.
The US Community Re-Investment Act (CRA): requires banks to invest a
certain portion of their portfolio in the local economy where the bank is
based, especially supporting those consumers that are historically
marginalized. The CRA has helped create an entire sub-sector of
community development financial institutions in the United States, which
specialize in providing access to capital and credit to low-income and
distressed communities.
12
5.2 Regional financial services markets and regulation
At the EU level, many changes in laws and regulations are being undertaken to create a
single financial services market (European Financial Services Action Plan). By 2005, all
financial services and financial markets are supposed to be liberalised to make different
(sub-)sectors of the EU financial industry compete against each other.
13
In this context,
the EU has been working on EU-wide supervision and regulation, including on financial
conglomerates that combine banking, insurance and securities' services, and on
eliminating tax evasion through tax havens and off shore centres. The new European
financial institutions work in a decentralised way to refine and implement EU financial
regulations
14
:
The Committee of European Banking Supervisors (CEBS)
The Committee of European Insurance and Occupational Pension supervisors
(CEIOPS)
The Committee of European Securities Regulators (CESR)
Other regions and free trade areas are equally setting up regional regulatory and
supervisory agencies. For instance, the Eastern Caribbean Central Bank covers 9 small
island members
15
in the Caribbean region.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 132
5.3 International regulation and supervision of corporate
financial services
Different international institutions set standards for national regulators and develop
measures to deal with cross-border activities of financial firms. Developing countries are
not always member of these international institutions or standard setting committees. The
standards, principles, agreements, guidelines and recommendations for regulation and
supervision made by these institutions do not have the status of international law. Their
status contrasts with the international binding agreements and rules of the World Trade
Organisation and the enforcement through the WTO mechanism that settles disputes
when members do not observe a WTO rule.
Many non-binding international financial standards may not yet be implemented,
especially not in developing countries. This state of affairs needs to be seen not only in
the context of increasing consolidation but also continuing worldwide arrangements to
liberalize trade in financial services. Complex Western financial conglomerates get the
right to operate in many developing countries even if international financial regulatory
standards are not generally applied (see chapter 6 about GATS).
The financial services industry itself is interested in having more equal rules and
supervision in all the countries in which it operates. This would create a "level playing
field" whereby foreign financial firms enjoy the same opportunities to compete in all
countries without being hindered by different requirements or preferences for national
financial firms. On the one hand, the financial industry is often heavily involved in
international standard setting bodies to stop any standard that would put too many
restrictions on their international operations or be too costly to implement. On the other
hand, the financial industry considers the current level of international regulatory
coordination (see below in this chapter) as insufficient.
The major international institutions that deal with regulation and supervision of financial
services are described in the following paragraphs. They are first mentioned in a short
oversight
16
with basic references; the most important institutions are more fully described
thereafter. The institutions that equally deal with the regulation and supervision of capital
flows and international financial system are briefly mentioned in the final parts of this
chapter.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 133
Short oversight of international supervisory and regulatory bodies
Basel Committee on Banking Supervision (BCBS): The BCBS provides an important
forum for regular cooperation among its 13 member countries on banking supervisory
matters. The BCBS formulates broad supervisory standards and guidelines and
recommends statements of best practice in banking, in the expectation that bank
supervisory authorities will take steps to implement them.
http://www.bis.org/bcbs/index.htm
International Association of Deposit Insurers (IADI): The IADI promotes international
cooperation and exchange of know-how among deposit insurers and other interested
parties. It aims at contributing to financial stability by providing guidance for more effective
deposit insurance and enhancing understanding of common interests.
http://www.iadi.org
International Association of Insurance Supervisors (IAIS): The IAIS allows insurance
regulators and supervisors from more than 100 jurisdictions to cooperate. It is charged
with developing internationally endorsed principles and standards that are fundamental to
effective insurance regulation and supervision.
http://www.iaisweb.org
International Organisation of Securities Commissions (IOSCO): IOSCO brings
national regulators together to develop and promote standards to regulate markets dealing
in securities and futures. It also develops standards for effective surveillance of
international securities markets. It provides mutual assistance to promote a rigorous
application of the standards and effective enforcement against offences in order to
safeguard the integrity of securities' markets.
http://www.iosco.org
Committee on Payment and Settlement Systems (CPSS): The CPSS monitors and
analyses developments in domestic payment, payment settlement and clearing systems
as well as in cross-border schemes by Central Banks and the private sector. The CPSS
deals with the different systems that settle the transfer nationally and worldwide of several
trillion dollars per day from interbank and other large value payments, transactions in
securities (including lending of securities) and derivatives, foreign exchanges, central
banks, and retail banking activities. The CPSS formulates broad supervisory standards
and guidelines for best practice, in the expectation that bank supervisory authorities will
take steps to implement them at national level. It has developed a common set of
universal international standards for payment systems: the “Core Principles for
Systematically Important Payments Systems”, published in January 2001. It has so far
failed to work out currency taxes such as a Tobin tax to slow down the billions of
international speculative capital flows.
http://www.bis.org/cpss/
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 134
CPSS-IOSCO Task Force on Securities Settlement Systems: The CPSS and the
Technical Committee of IOSCO set up a task force to jointly issue recommendations for
securities settlement systems.
http://www.bis.org/cpss/index.htm; http://www.iosco.org
BCBS Transparency Group and IOSCO TC Working Party on the Regulation of
Financial Intermediaries: Together both bodies made recommendations for public
disclosure of trading in securities and derivative activities of banks and securities firms.
They complement the surveys by both Committees on disclosure of trading and
derivatives by banks and securities firms. Such surveys have been published annually
since 1995. Both initiatives form part of a continued effort to encourage banks and
securities firms to provide market participants with sufficient information to understand the
risks inherent in their trading and derivative activities.
http://www.bis.org/bcbs/index.htm; http://www.iosco.org
5.3.1 Bank for International Settlements (BIS)
The Bank for International Settlements (BIS)
17
is an international organisation that was
established in Basel (Switzerland) in 1930 and serves as a bank for central banks. The
BIS currently has 55
18
member central banks. The aim of the BIS is to promote
international exchange of expertise and cooperation on national and international
monetary and financial issues. The different Committees of the BIS have agreed upon
some arrangements to regulate and supervise particular banking issues in order to
achieve financial stability. The committees determine their own agenda and operate
independently from the BIS' governing bodies. The Basel Committee on Banking
Supervision is the most important committee.
Developing banking supervisory cooperation and standards: the "Basel
Committee"
The Basel Committee on Banking Supervision started in 1974 as a forum for regular
cooperation between banking supervisors of 10 Western countries (G-10) and exists
currently of supervisory authorities and central banks of 13, developed, countries.
19
It is
referred to as the "Basel Committee" and has subgroups that deal with particular banking
supervision issues (e.g. securitization). The Committee consults and exchanges know-
how with supervisors of other countries that have important financial industries. It has a
strong focus on strengthening prudential supervisory standards in so-called, non member,
emerging markets. The Committee also has close links with the international banking
industry, assuming that these links help to forge consensus. There are no particular
consultative bodies with other actors of society but consultative papers often request for
comments, by any one, by a certain deadline and informal consultations take place with
private banks.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 135
Arrangements to supervise nationally and internationally operating banks
The Basel Committee has gradually developed common international standards of
banking supervision that are to be implemented through national legislation. It has
increasingly become a standard-setting body on all aspects of banking supervision and
best banking practices. The Committee, however, has no international means of
enforcement. The standards aim at preventing erosion of regulation when national
authorities want to attract foreign investment in financial services or protect their financial
services industry against foreign competitors. The Committee is concerned about
intensification of international competition in countries with insufficient supervision.
The main important instruments developed by the Basel Committee are:
- The Basel Committee’s Concordat embodying principles of effective banking
supervision:
In 1975, after a crisis in the foreign exchange markets, the Concordat established the
principle that the home country authorities would supervise some establishments of
worldwide operating banks. The concordat was strengthened several times, for instance in
1983
20
, and in the aftermath of one of the biggest ever collapse of a financial company,
the Bank of Credit and Commerce International (BCCI) in 1991
21
. Especially branches of
international banks are to be supervised by the authorities of the parent bank. Supervision
of subsidiaries and other activities of banks' foreign establishments is to be done jointly by
the host and home country authorities. In 1990, recommendations were made to improve
information exchange between host and home supervisors because it was often
inadequate.
22
- The Basel Committee's Minimum Standards for the supervision of international banking
groups and their cross border establishments:
These standards, agreed upon in 1992, provide the right of the home country supervisors
to obtain data needed for the consolidated supervision of international banks and
strengthen the host countries’ authority to impose restrictive measures if the minimum
standards are not met. Such prudential measures include imposing deadlines for meeting
acceptable standards, obliging foreign branches to be restructured so as to have sufficient
capital reserves, and even closing banking establishments.
23
- The Basel Committee’s 25 Core Principles for Effective Banking Supervision:
These 25 core principles were agreed upon in September 1997 after the G-10 also
consulted authorities of "emerging markets". They represent the basic elements for an
effective banking supervisory system in each country. Supervisory authorities throughout
the world were invited to endorse the principles. By endorsing, countries agreed to have
their supervisory arrangements reviewed against the principles.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 136
Regulation of capital reserves for lending: the Basel Capital Accord and its
renewal
"Basel I": a major international standard of banking supervision
The supervisors of the Basel Committee agreed in 1988 on the amount of financial
reserves they require all banks to put aside when providing loans. This agreement about
the "capital requirements" by supervisors to their banking industries was called the "Basel
Capital Accord" and was updated several times to avoid misunderstandings and major
gaps. The aim was to address "credit risks" in order to avoid that banks would go bankrupt
by a series of bad loans that were not being repaid. Because of competition,
internationally operating banks were holding as less capital reserves as possible. The
danger was that the banks' reserves were becoming too low to recover from major non-
performing loans.
The basic principles of the Basel Accord are:
A bank has to put aside 8%, or less, of the amount of the loan as a reserve,
depending on the assessment of the risks of a loan.
Banks have to make assessments in how far a loan will not be repaid based on three
categories, i.e. governments, banks and corporations. For instance, a bank that gives
a loan to a government in an OECD-country has to put no money aside because the
risks of non-repayment are none according to the Basel principles. According to Basel
I, banks have to put aside 8% of all loans provided to any corporation. In practice,
however, loans to large companies are assessed to have less risks of non-
performance and are therefore provided at lower interest rates by banks compared to
loans to small and medium-sized companies.
Table: Basel I risk assessment framework
% credit risk in OECD
countries*
% credit risk in non-OECD
countries*
Official authorities (e.g.
governments)
0% 100%
Banks:
-loans up to 12 months
-loans of 12 months and
longer
20%
20%
20%
100%
Corporations 100% 100%
* 100% risk means banks have to put 8% of the amount of the loan aside as a reserve
Source: |. |etzger, 8asel ÌÌ · 8enefIts for 0evelopIng CountrIes, 8ÌF
WorkIng Paper Nr. 2 /2004 (based on 8asel CommIttee 1988)
Banks that give loans to other banks have to distinguish between short term loans (up
to 12 months) and long term loans. According to Basel I, the risk of providing short
term loans to banks is much less (only 20% risk) than long term loans (100% risk in
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 137
developing countries). Because the financial crisis in Asia (1997-'98) was caused
amongst others by short term loans given by Western banks to local banks in South
East Asia, the Basel Committee has started to draw up new principles according to
which banks have to assess the risks of a loan.
By 1994, the original Basel Accord was being implemented in over 100 countries. The
Accord Implementation Group was set up by the Basel Committee to share experiences
and promote implementation.
"Basel II": a significant reform that affects the banking industry worldwide
In May 2004 the Basle member countries reached a consensus on a new capital Accord,
dubbed Basel II, that will introduce some important reforms in banking sector supervision
related to credit risk management. Basel II intends to make the banking system more
stable and efficient by enabling banks to hold capital reserves based on a more
sophisticated risk assessment of their credit provisions to others. The new accord is to be
implemented by the end of the year 2006.
It has to be noted, however, that the exact implementation process is unclear. Already in
the preparation phase, there was much controversy surrounding the new accord.
Proposals proved to be heavily influenced by international operating banks, for instance
through the Institute of International Finance.
24
Even before the text Basel II had been
agreed upon, the US and China already announced that they would pursue other
regulations for most of their (national) banks
25
so that not all banks will apply Basel II as
originally conceived. The US House Financial Services Committee feared that Basel II will
disadvantage smaller US banks who have no capacity to apply Basel II, and increase the
concentration in the banking industry.
26
As for the European Union, the EC is planning to implement to entire new accord into a
third European Capital Adequacy Directive (CAD3), which will make the Basel II principles
applicable to all European credit institutions.
As for less developed countries, the Basel Committee acknowledged that the adoption of
Basel II might not be the first priority of supervisors in those countries. They should focus
more on the implementation of pillar 2 and 3 of the Accord (supervisory process and
market discipline), rather than on the complex reserve requirements of pillar 1.
27
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 138
Box: The main elements of the new Basel II accord
The text of the new accord (Basel II) is a complex document of 250 pages. It is based on three
pillars:
Pillar 1: New risk assessment mechanisms and resulting capital requirements:
New categories are introduced on how loans to governments, banks and corporations need to
be assessed, as well as new minimum capital reserve requirements.
Different approaches to measure credit risk:
a "standardised approach" to measure the risks of a borrower, where banks for their credit
assessments depend on corporate rating agencies (see chapter 1) that assess solvency; or
a bank can use its own risk estimation systems ("Internal rate based approach" or IRB
approach) and comply with certain criteria and information disclosures, e.g. sufficient auditing.
Banks increasingly transfer their asset risks to outside investors through securitization, and
therefore Basel II has introduced a securitization framework to assess the risks associated with
this and to determine the resulting regulatory capital requirements. Again, the accord offers a
standardized approach, and the option to use an internal rate based approach. The capital
reserve requirements depend on the approach used.
28
Introduction of capital requirements for operational risk, the risk associated with the internal
processes of the bank. Basel II offers 3 different approaches, varying in complexity, to assess
these risks.
A final element of the first pillar concerns the trading book. The trading book (in contrast to the
banking book) gives an overview of a bank’s financial instruments it holds for trading purposes.
This balance has become much more important for banks, and clearer rules are introduced on
how to treat trading book issues.
Pillar 2: Changes in the supervisory processes:
Banking supervisors get more power and scope to intervene and monitor risk assessment
systems of banks.
Banking supervisors of the home countries and host countries of banks are required to improve
their cooperation and information exchange and make concrete plans thereto, and decrease
the burden of banks to implement supervisory requirements.
29
Pillar 3: Market discipline through better disclosure of information by banks:
Banks have to publicise more differentiated data. The assumption is that when data indicate
bad banking behaviour, e.g. too many risky loans, the clients and investors will react and put
pressure on the bank.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 139
Critical issues about "Basel II"
In the preparation phase of the new accord, the Basel Committee had already
requested, and received, comments on its three consultative papers. There have
been many articles by experts who have criticised the Basel II proposals. The
definite version of the Accord has not taken account of many of these critiques. In
the end, it seems that the major aim of Basel II is avoiding that Western
governments would have to bail out the large consolidated Western private banks
in case they fail.
The overview below sums up some problems for developing countries and
safeguarding financial stability.
30
Developing countries not represented
The Basel Committee that negotiated and designed the Basel II Accord did not
have representatives of developing countries among its members. The Committee
did hold regular meetings with a group of 13 non-member countries, including
Russia and China, to review its work and comment upon it. However, the new
capital accord Basel II failed to take account of the interests of developing
countries who had no decision-making power in the design.
Loans to developing countries more expensive?
Governments, banks and corporations in developing countries will probably face
higher costs for loans due to Basel II. First of all, this could be the case since they
generally receive low ratings by rating agencies or by the banks' own risks
assessment systems. Many companies or governments from developing
countries have no rating at all. These lower or non-existing ratings do not always
reflect actual creditworthiness of the corporations or governments and can reflect
some bias in capital markets. According to the “internal ratings based” (IRB)
approach in Basel II, banks do need to put more capital aside for such lowly or
non-rated lenders. In practice, this would mean that higher interest rates will be
charged for many loans to developing countries compared to the developed
world.
Secondly, interest rates charged to the developing world as a whole could be too
high because of the lack of diversification considerations, which Basel II has
chosen not to include in its risk assessment mechanism. The economies of the
developing world are normally less related to the developed world as a whole, so
that they are much less affected in case of a crisis in the industrialized world. To
avoid risks, banks should therefore not only diversify their credit portfolio among
sectors, but also among the developed and developing world. There exist tools to
assess investment risks that take those diversification considerations into
account. However, the mechanisms adopted in the Basel II accord haven’t
integrated them. As a result, the estimated credit risk of loans to developing
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 140
countries could lay as much as 20% too high
31
and, consequently charged
interest rates could be much too high as well.
A positive consequence of the higher reserve requirements, on the other hand,
could be that it would become easier for banks to reduce developing countries’
debt burden by writing off loans. Since banks have already better covered for
non-performance, by making higher provisions for a loan to a developing country,
writing off such a loan would be relatively less costly for a bank.
International banks get competitive advantage
Banks that use their own risk assessment system have to use their system for all
the loans they provide in all countries. The costs of introducing and operating own
risk assessment systems are expensive and especially feasible for the top of
internationally operating banks. Consequently, the different banks that operate in
a particular developing country might use different risk assessment approaches
with different capital reserve requirements. This would give international banks
that use their own risk assessment system ('Internal rate based' approach (IRB)'
with less capital requirements) a competitive advantage over domestic banks that
use a standardised approach requiring higher loan reserves.
Too complex tasks for supervisors?
The question remains whether supervisors will be able to duly supervise the
implementation of the banks' own risks assessment mechanisms (IRB approach).
During the design of Basel II supervisors indicated that they did not fully
comprehend these risk assessment systems.
32
Supervision of banks that use
their internal ratings mechanisms will require supervisors to work closely together
with those banks. The supervisory bodies will also have to invest heavily in their
own expertise to ensure they can actually judge the banks’ assessments. It is
doubtful whether the regulatory regime is strong enough for this.
33
Danger of financial instability not resolved
Short term loans are still treated more favourably than long term loans because of
the much lower reserve requirements attached to the former. Although the Asian
financial crisis has shown that short term loans can be the source of major
financial instability, the new Accord hasn’t taken this into account.
34
Another
potential danger to financial stability lies in the possible procyclical effects of the
use of external rating agencies for the assessment of risks. When a country is
temporarily not doing too well, and rating agencies start to lower credit ratings,
this could only aggravate the situation.
35
Lack of assessing environmental and social risks of the borrowing
companies and governments
One critique professional experts have not publicly raised is that assessing credit
risks should also take into account the risks for sustainable development, i.e. the
environmental degradation, the social and societal impacts of the companies and
projects that receive bank loans. The Basel II only has an obligation to banks to
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 141
assess environmental risks that undermine the value of the collateral of the
borrowing company.
36
Other assessment mechanisms more useful
37
There are other ways that would be helpful to prevent financial instability and
bailing out. Such alternative system would be based on the systemic risks a bank
poses to the international financial system: The more a bank is big and
internationally interconnected, the higher the capital requirements should be; also,
the better the bank is in predicting and assessing risks, the less capital reserves it
would have to put aside. In addition, capital requirements should not remain the
same at any time but be raised in times of financial instability and crisis.
5.3.2 International Association of Insurance Supervisors
(IAIS)
38
The IAIS was established in 1994 to promote cooperation and transfer of know how
among insurance supervisors. It is charged with providing guidance and developing
internationally endorsed principles and standards that are fundamental to effective
insurance regulation and supervision. It strives to contribute to financial stability and
coordinates with regulators of other financial sectors.
IAIS members are insurance supervisory authorities from more than 100 jurisdictions. In
addition, there are 70 observers form professional organisations, insurance and
reinsurance companies, international financial institutions, and other individual
professionals.
The IAIS has 21 working parties meeting 3 to 4 times a year and dealing with particular
issues of the insurance industry such as accounting, reinsurance, insurance fraud,
electronic commerce, investments, emerging markets, disclosure and transparency.
Through its working parties, IAIS members have developed and approved several
standards of which important ones are:
The IAIS Core Principles and Methodology for effective operation of supervisory
systems (2000): the principles were updated in October 2003 to add issues of
transparency of the supervisory process, risk assessment, consumer protection
and anti-money laundering.
The Insurance Concordat (1999): covers principles to improve the supervision of
internationally operating insurance companies and their cross-border business
operations, including cross border insurance business that is conducted without
foreign establishment (e.g. through internet). The concordat promotes
cooperation between supervisors from the home and the host countries.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 142
IAIS's recent work on standard setting has focused on developing standards in the areas
of:
solvency;
cross-border service provision;
asset risk management;
group coordination of financial conglomerates;
reinsurance;
market conduct;
electronic commerce;
accounting standards (whereby it works closely together with the International
Accounting Standards Board, see 5.5)
In 2003 it also published a study about the risk of some 15-20 insurance companies
buying credit derivatives (see chapter 1), and other issues of credit risk transfer between
insurance, banking and other financial firms. The study was inconclusive as it indicated
that it is difficult to gather all the relevant global data but suggested that credit derivatives
were only a relatively small proportion of insurers' investments, and thus not posing major
risks of transferring risks from the banking to the insurance industry.
39
5.3.3 International Organisation of Securities Commissions
(IOSCO)
40
Since 1983, IOSCO has been bringing national securities regulators together to cooperate
and exchange experiences in order to maintain "just, efficient and sound" securities
markets. It has been developing principles and practices for sound regulation of securities
markets and financial firms, and standards for effective surveillance of international
securities markets. It provides mutual assistance to promote application of the standards
and effective enforcement against offences.
IOSCO is recognised as being the international standard setter for the securities industry
although it has no other mechanisms to enforce its resolutions, statement and standards
than screening regulations, naming and shaming, and cooperation.
The ordinary members include securities regulators of over 100 jurisdictions. "Self
regulating bodies" such as the stock exchanges (which are in private corporate hands)
can become affiliate members or even ordinary members if coming from a country without
governmental securities regulatory bodies. IOSCO has several committees according to
regions and the development of the securities' market, including an Emerging Markets
Committee.
The importance of IOSCO became clear during the South East Asian financial crisis in
1997-98. The "emerging markets" had seen the cross-border trade in their securities grow
very rapidly, amongst others by deregulation, and trading by Western financial firms and
mutual funds. When uncertainty about South East Asia's financial stability hit the
securities markets, high volatility in securities trading followed from investors and banks
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 143
selling off their shares in search of short term protection against losses. The financial firms
that traded in securities gained from the fees of increased trading but the resulting
volatility in exchange rates and devaluation in the South East Asian currencies and
companies' shares was so severe that it contributed to the economic and social downturn
of those countries.
In 1998, IOSCO issued the 'IOSCO principles', a document with 30 principles which
securities regulators committed themselves to implement, aiming at:
1. protecting the investors,
2. ensuring fair, efficient and transparent markets,
3. reduction of systemic risk.
These "Objectives and Principles of Securities Regulation" have been recognized as key
standards for a stable and well functioning securities market and were updated in 2002.
Promoting these principles, which are not legally binding, is one of IOSCO's highest
priorities, supported by a task force, and self-assessment mechanisms for its members.
The IOSCO principles were strengthened by the adoption of the “Multilateral
Memorandum of Understanding Concerning Consultation and Cooperation and Exchange
of Information” (“IOSCO MOU”), This agreement should enhance the enforcement of the
principles and avoid the use of securities for criminal purpose. Many IOSCO members
could not yet subscribe to the IOSCO MOU because they could not implement all the
Principles. At the end of 2004, only 26 out of the 105 IOSCO members had signed the
MOU. On the other hand, some members already had such cooperation agreements at
bilateral level ("bilateral MOUs").
IOSCO followed the general line by supervisors and regulators after the financial crisis
that more disclosure of information can avoid a financial crisis. For instance, in 1999
IOSCO issued "Recommendations for public disclosure of trading and derivatives
activities of banks and securities firms" in cooperation with the Basel Committee on
Banking Supervision.
41
In September 2003, IOSCO issued a Statement
42
with general principles to guide
securities regulators in addressing conflicts of interest faced by financial analysts.
43
This
was a response after scandals had uncovered that securities analysts were advising
investors to buy securities from companies which were clients from other divisions in the
financial firm of the securities analysts (conflict of interest). Although IOSCO had
recognised the role of regulators in deterring manipulation and unfair trading practices in
its 1998 principles, IOSCO's statement came after the stock market bubble, inflated by this
conflict of interest practice, had burst and many investors had lost their money and
confidence in the stock-market
(see chapter 1).
At the end of 2004, IOSCO announced the plan to press offshore markets to cooperate
better with securities regulators. After frauds at for example Parmalat, the role of offshore
markets in securities markets became apparent, and IOSCO expressed its concern that
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 144
those offshore markets were standing in the way of effective market supervision. Only 1
offshore centre has actually signed the MOU (Jersey) but other offshore centres are
pressed to follow in order to enable information exchange
44
.
The implementation of IOSCO's broad and general principles was left to the national
authorities and the financial industry itself. One measure of implementation was the total
split between activities of securities analysts and investment banking, thus undoing some
aspects of consolidation.
5.3.4 Supervising and regulating all-finanz firms
Each of the above mentioned institutions have tackled some of the problems that
consolidation in the financial industry brings. In addition, the Basel Committee on Banking
Supervision, IAIS and IOSCO established a Joint Forum in 1996. The Joint forum
examines supervisory issues relating to financial conglomerates that combine banking,
insurance and securities activities and that develop new financial services in which the
distinctions between the three activities are blurred (e.g. loans combined with life
insurance and investment in securities).
The work and the reports
45
of the Joint Forum focuses on avoiding instability in the
financial markets and financial industry by:
increasing the understanding the differences and similarities for supervisors of
banking, insurance and securities activities (e.g. outsourcing in financial services
and credit risk transfer),
proposing supervision measures for consolidated firms, and
stimulating cooperation among the relevant supervisors.
The Joint forum has only members of 13 Western countries. The Central banks authorities
of these countries also meet in the Committee on the Global Financial System (see
below).
Most of the official advise on consolidated financial firms given by experts to supervisors
and regulators does not go beyond more cooperation between supervising and regulatory
authorities, swifter action in case of potential crisis, and better information disclosure so
that clients and investors can react when information show flaws in the operation of a
financial conglomerate ("market discipline").
46
Critical issues
No comprehensive response to consolidation strategies
The current international supervision and regulatory mechanisms have not come
up with a comprehensive response to the trends and activities of internationally
operating financial firms although the complexity of not only one financial
conglomerate, but also the interconnectedness and interdependence of financial
conglomerates, is still very difficult to oversee and different scandals indicate that
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 145
financial firms do manipulate markets.
47
They were even not able to form an
integrated international body to regulate and supervise the different worldwide
activities of consolidated financial firms: the Joint Forum falls far short of what is
necessary. Experts and studies by the above mentioned bodies indicate that
supervisors and regulators are still left with important challenges
48
such as:
Uncertainty about the risks of consolidated financial firms. What
seems to be clear, however, is that if a large and complex financial firm
became impaired, than the closing down of such a firm will likely to be
disorderly and have broad implications on the economy.
Uncertainty about the future shape of financial sector consolidation:
consolidation might fully continue leading to a few dominating financial
firms, or outsourcing and/or the creation of specialised financial firms
might give consolidation a particular shape
Unpredictability and uncertainty about the threat to financial
instability: assumptions are that instability is likely to come from
increased transborder and wholesale
49
activities, the swiftness of the
capital moves, the worldwide interconnectedness in particular financial
sub-sectors and the increasing interdependencies between the leading
financial firms (e.g. through interbank loans, credit derivatives).
Insufficient information is published by consolidated banks to their
clients, investors and supervisors, which would enable the latter to see
whether too many risks are being taken.
50
A review of the annual reports
of fifty-four international banks in 2001 showed that they disclosed only
63% of the items considered important by the Basel Committee of
Banking Supervision. While that was an improvement over the previous
years, it was still far from sufficient. In particular, information about their
techniques for mitigating credit risks (including the more speculative
credit derivatives) was lacking, which makes it difficult to monitor from the
outside their practices and expertise for avoiding bad loans, a major
source of (in)stability.
Consolidation does not lead to spectacular increases of efficiency
while the consumers get less favourable conditions and SMEs get less
loans from consolidated firms.
A small number of leading financial firms increasingly dominate
some specific activities, such as investment banks and payment and
settlement services. Such domination might lead to abuse of market
power e.g. higher prices, and to risks to the financial system e.g. if the
payment services were to fail.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 146
Continued difficulties to monitor the internal capital flows within a
consolidated bank. Payment and settlement flows increasingly become
between a few parties or in-house transactions.
5.4 Regulation, supervision and decisions related to
capital flows and the international financial system
In addition to standards on how to regulate and supervise the behaviour of financial
services companies, there are international institutions that deal with issues to prevent the
international financial system from collapsing and to ensure stability of international capital
flows and financial markets. As capital flows and financial markets are the instruments of
the financial firms, the themes under discussion and review in these institutions are
sometimes closely related to regulatory and supervisory issues. The institutions described
below deal much more with the wide ranging discussion about the “international financial
architecture” that has regained importance after the Asian financial crisis in 1997-98
because it damaged many economies and citizens of “emerging markets”. It is however
beyond the scope of this report to deal with these institutions and issues in detail.
The discussions about the reform of the financial architecture are organised around the
following issues
51
:
Macroeconomic policy and data transparency:
monetary and financial policy transparency
fiscal transparency
data dissemination
data compilation
Institutional and market infrastructure:
insolvency
corporate governance
accounting
auditing
payment and settlement
market integrity
market functioning
Financial regulation and supervision:
banking supervision
securities regulation
insurance regulation
financial conglomerate supervision
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 147
5.4.1 International fora for discussing financial system
stability
The issues to prevent an international financial crisis are mostly discussed in the following
important international institutions. A short overview
52
in this report describes these
institutions in short with references that allow further monitoring.
The Financial Stability Forum without enforcement mechanisms
The Financial Stability Forum (FSF) was convened in April 1999 to improve the
functioning of markets and reduce systemic risk. It regularly brings together senior
representatives of financial authorities (e.g. central banks, supervisory authorities and
treasury departments) from 11 financially important countries
53
, 6 international financial
institutions, 7 international regulatory and supervisory groupings, 2 committees of central
bank experts and the European Central Bank. The FSF has no enforcement mechanisms
but proceeds through information exchange, and international cooperation and
coordination in financial supervision and surveillance. During its meetings, it assesses the
state of vulnerability of the international financial sector.
12 Key Standards for Sound Financial Systems
The Financial Stability Forum has highlighted 12 standards as key for sound financial
systems and deserving of priority implementation by all countries. While the identified key
standards vary in terms of their degree of international endorsement, they are
internationally broadly accepted as representing minimum requirements for good practice
and resulting in beneficial effect on the stability of national and international financial
systems. Some of the key standards are relevant for more than one policy area.
Critical Issues in the Financial Industry
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Table: Key standards promoted by the Financial Stability Forum
Area Standard Issuing Body
Macroeconomic policy and
data transparency
Monetary and financial policy
transparency
Code of Good Practices on
Transparency in Monetary and
Financial Policies
IMF
Fiscal policy transparency Code of Good Practices in
Fiscal Transparency
IMF
Data dissemination Special Data Dissemination
Standard (SDDS)/
General Data Dissemination
System (GDDS)(1)
IMF
Institutional and market
infrastructure
Insolvency (2) World Bank
Corporate governance Principles of Corporate
Governance
OECD
Accounting International Accounting
Standards (IAS)(3)
IASB (4)
Auditing International Standards on
Auditing (ISA)
IFAC (4)
Payment and settlement Core Principles for
Systemically Important
Payment Systems
Recommendations for
Securities Settlement Systems
CPSS
CPSS/IOSCO
Market integrity The Forty Recommendations
of the Financial Action Task
Force on Money Laundering /
8 Special Recommendations
Against Terrorist Financing
FATF
Financial regulation and
supervision
Banking supervision Core Principles for Effective
Banking Supervision
BCBS
Securities regulation Objectives and Principles of
Securities Regulation
IOSCO
Insurance supervision Insurance Core Principles IAIS
Source of table: http://www.fsforum.org
Notes:
1) Economies with access to international capital markets are encouraged to subscribe to the
more stringent SDDS and all other economies are encouraged to adopt the GDDS.
2) The World Bank is co-ordinating a broad-based effort to develop a set of principles and
guidelines on insolvency regimes. The United Nations Commission on International Trade
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Chapter 5 – Governmental regulations at the international level 149
Law (UNCITRAL), which adopted the Model Law on Cross-Border Insolvency in 1997, will
help facilitate implementation.
3) Relevant IAS are being reviewed by the IAIS and IOSCO.
4) The International Accounting Standards Board (IASB) and the International Federation of
Accountants (IFAC) are distinct standard-setting bodies in that they are private sector
bodies.
Committee on the Global Financial System (CGFS)
54
is a forum of the rich
The CGFS, composed of the Central Banks of 13 rich countries, undertakes:
systematic short-term monitoring of global financial system conditions,
longer-term analysis of the functioning of financial markets, and
the articulation of policy recommendations aimed at improving market functioning
and promoting stability.
It has developed a list of general principles and more specific policy recommendations for
the creation of stable securities markets. It has set up a Working Group on incentive
structures in institutional management. The Working Group published a report in March
2003 about the evolution of the asset management industry (e.g. mutual funds, pension
funds, insurance companies) and its impact on financial stability, as it is a financially
important sector.
International Monetary Fund (IMF)
55
more active on financial crisis prevention
The work of the IMF is of three main types.
1. Surveillance that involves the monitoring of economic and financial developments,
and the provision of policy advice aimed especially at crisis-prevention.
2. Lending to countries with balance of payments difficulties, providing temporary
financing and supporting policies aimed at correcting the underlying problems; loans
to low-income countries are also aim at poverty reduction but include harsh
conditionality based on free market policies.
Technical assistance and training in areas of IMF expertise.
Supporting all three of these activities is the IMF's work in economic research
and statistics.
The International Financial Committee that meets at the bi-annual meetings of the IMF
attended by most Ministers of finance have been a key forum to take decisions, or
obstruct decisions, on measures for the reform of the international financial architecture.
A major problem is the lack of proper voting rights by developing countries, which is now
being discussed with little progress.
Since the financial crisis of 1997-98, the IMF's work has more focused on crisis
prevention. It improved the availability of important information (e.g. levels of countries’
external debt, financing in emerging markets) and publishes twice a year the Global
Financial Stability Report. In collaboration with other standard-setting bodies, it has
developed international standards for data dissemination and transparency practices in
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fiscal, monetary and financial policies, and has contributed to the development of
international standards for banking supervision.
The IMF has together with the World Bank implemented the Financial Sector Assessment
Programme - FSAP which identifies strengths and vulnerabilities of a country's financial
system and helps to deal with the latter. Under the programme, country reports are
prepared with information on how a country implements financial standards and codes of
best practice. In these country reports, the IMF also looks at the state of the financial
industry and seems to favour consolidation of the financial industry at national level. In a
report on the German banking system, the IMF called for a modification in banking
regulations to allow merger processes that would do away with state owned banks and to
accelerate consolidation in the sector.
56
The Financial Sector Reform and Strengthening
(FIRST) Initiative is a US$ 53 million multi-donor program, supporting capacity building
and policy development projects in the financial sectors in developing countries.
In its normal lending and advisory activities, the IMF is now much less insisting on (full)
liberalisation of capital flows (capital account liberalisation) as it did before the Asia
financial crisis. Too swift liberalisation of capital flows is increasingly recognized as
contributing to financial crises.
As part of the Offshore Financial Centres Assessment Programme, IMF staff undertakes
detailed assessments of the extent to which offshore financial centres meet the standards
advocated by the international standard-setting bodies. It assesses any further action
required to meet these standards such as technical assistance. It also collaborates with
standard-setters and supervisors to strengthen standards.
The Organisation for Economic Cooperation and Development (OECD)
57
has
unfamiliar code to liberalise capital flows
In general, the OECD promotes policies and efficient functioning of markets to achieve
economic growth and employment in its member countries.
58
It encourages the
convergence of policies, laws and regulations covering financial markets and enterprises.
The OECD division on finance and investment stimulates discussions on the many
issues related to finance and investment. It publishes an annual report with data and
trends about the profitability and health of the banking systems in 30 OECD countries.
59
The OECD division on insurance and pensions is equally a forum to discuss and study
issues and problems in those respective sectors. It includes the OECD Insurance
Committee and the Group of Governmental Experts on Insurance Solvency.
The OECD Code of Liberalisation of Capital Movements came into force in September
1961 and was regularly updated, lately in January 2003. This Code has played a very
important role in liberalizing capital flows, however this has gone unnoticed. Such
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liberalisation of capital flows allowed financial firms to expand their international activities
without restrictions on their international capital movements.
The Code contains obligations for OECD members to liberalise capital flows related
to:
direct investment (FDI),
securities (includes portfolio investment),
services,
loans,
insurance,
foreign exchange,
payments for imports and exports, and
personal capital movements.
It is based on principles such as non-discrimination between capital flows from OECD
members, transparency and exceptions to liberalisation (e.g. in the case of financial
problems).
Although the code is legally binding for OECD members it is not a treaty under
international law. The ultimate decisions on its monitoring and application lie with the
OECD Council. New members have to abide by the code but can be exempted from some
obligations for some time to avoid financial disturbances. Implementing the Code has had
an important impact on helping create the South East Asian financial crisis because it
pressed its new member South Korea to remove restrictions on financial flows, which
allowed risky, volatile and uncontrolled financial flows before and during the financial
crisis.
Action against money laundering and tax evasion by the Financial Action Task
Force on (FATF)
60
and OECD
The FATF, established in 1989, has set out a programme of forty "Recommendations" to
combat laundering money from corrupt and criminal activities. The recommendations were
updated in 1996 and again in 2002 in the wake of the 11 September 2001 terrorist attacks
against the U.S., when 8 Special Recommendations were added to the original forty. The
FATF monitors the progress by its 26 members in implementing measures to counter
money laundering, reviews money laundering trends, techniques, and counter-measures,
and promotes the adoption and implementation of the FATF Recommendations by non-
member countries.
The FATF is based at the OECD that also attempts to deal with offshore centres because
they facilitate money laundering and tax evasion, resulting in tax competition harming
OECD countries. Many countries with tax havens and offshore centres have reacted
disapprovingly to the OECD. While improving some of their regulatory oversight, they
resist amending their low taxation policies. The Caribbean countries threatened to use the
WTO when the US, Canada and Japan warned their financial firms to be wary of doing
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business with he Caribbean offshore centres. The latter considered these warnings as
restrictions on trade in financial services with those centres.
61
The exclusive G-7 and some input by developing countries in the G-20
Since 1986, decisions about exchange rates and international financial stability have for
an important part been taken by the Finance Ministers of the Group of Seven richest
countries in the world (G-7: Canada, France, Germany, Italy, Japan, UK, US). Russia
joined the G-7 (G-8) and attends most meetings of the G-7 meetings of finance ministers.
This exclusive and non-transparent informal forum has been discussing many important
issues that were also being discussed at other fora dealing with financial stability. It
recently played an important role during the financial instabilities that started in 2001 after
the September 11 attacks and the fall of the stock market. The financial reserves of banks
and insurers that had invested in shares were dropping dramatically and the G7 leaders
took the decision not to pressure banks and insurance companies to keep up the required
reserves. Otherwise these financial firms would have been forced to sell their low-valued
shares for other financial assets, resulting in massive sales of shares, which would have
further decreased the value of equities at the stock market. Moreover, the Central banks
decided to intervene by lowering interest rates and providing massive extra credit to the
commercial banks.
62
When the G-7 takes a decision to introduce a measure, or to intervene in the major
exchange rates, this has wide ranging effects on other countries who have no say in the
forum. Because the so-called “emerging markets” have the last two decades plaid an
increasingly important role in financial flows and financial crises, the G-7 has decided to
convene a Group of Twenty (G-20) to discuss issues of global financial stability between
the G-7 countries and other countries with important financial flows or financial risks such
as Argentina, Australia, Brazil, China, Mexico, Saudi Arabia, South Africa, Korea and
Turkey.
5.4.2 State of the reform of the international financial system
Good ideas, little reform
The various fora mentioned above have identified and discussed many issues to avoid a
financial crisis by misbehaviour of governments and the financial industry. On the one
hand, standard setting for better regulation and supervision has progressed and the
situation in developing countries has improved through technical assistance and
monitoring programmes. Cooperation between different authorities, nationally and
internationally, also made progress. On the other hand, many of the standards deal with
past crises and only tackle issues that might lead to a financial crisis in the future. Some
standards were developed after damage has been done (e.g. IOSCO did not prevent
conflict of interest in securities trading).
Overall, real progress in applying the necessary restructuring measures is absent. In other
words, many good ideas but little reform. Introduction of new measures to reform the
international financial architecture has bogged down after an insolvency regulation for
sovereign debtors (states) was removed from the agenda at the 2003 Spring meeting of
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the IMF. However, the quick steps taken against money laundering and bank secrecy after
the 'September 11' attacks indicate that swift reforms in the financial architecture are
possible if there is enough political will to do so.
Many challenges left for developing countries
For developing countries the following important problems in the financial system are still
not solved. In case of a new financial crisis, their population and economies are likely to
have to carry the burden of the devastating effects. The financial crisis in Argentina and
Turkey are a case in point. Unresolved problems are:
Instability of capital flows
There is a political unwillingness, supported by the financial industry -and vice versa-, to
restrict the billion of dollars flowing daily across borders through financial firms and
financial markets for speculative and short term profit making. The discussions to
introduce capital controls such as a “tobin tax” have made little progress. Most worryingly,
the instruments used by governments to control and slow down cross-border capital flows
are being taken away in trade agreements (e.g. during the negotiations for a bilateral trade
agreement with Chile, the US pushed hard to remove the “Chile tax” which is
internationally recognized as an important financial stabilization instrument). There is little
political will to prohibit financial products from financial firms that are highly speculative
and create uncertainty, such as credit derivatives. Still, short term capital flows are
prioritised due to the Basel II accord (see 5.3.1).
No solution to a potential “moral hazard”
In the past, banks and other financial actors that undertook too risky operations that
resulted in bankruptcies had to be bailed out by governments in order to avoid total
destabilization of the financial system and the economy. In other words, taxpayers’ money
was used to cover the debts and losses of commercial and speculative financial actors. At
present, there has been made some improvement by adopting collective action clauses
(CAC’s) in the issuance of government bonds under New York law. These clauses state
that in case a government, which has issued bonds, is in financial stress, and a majority of
bondholders agrees to restructure the conditions (e.g. the payment terms) of the bonds
issues, a minority of bondholders can no longer block this process. In the recent past,
bondholders have often take legal action to make states (i.e. taxpayers) repay their
investments whatever the situation in the country. It is the question whether the
introduction of CAC’s will have a real impact: their use is still voluntary under New York
law, and normally it still takes 75% of all bondholders to agree on a restructuring.
There is no lender of last resort where governments can obtain temporary funds without
(the wrong) conditions attached to solve a financial crisis due to misbehaviour of the
financial industry. The current contingency credit line of the IMF is not functioning well as
countries are afraid to use it.
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Continued high debts in foreign currency by developing countries result from
insufficient international debt cancellation mechanisms and unfair arbitration mechanisms
to cancel or restructure governmental and commercial debt .
There is still quite some instability of exchange rates that damages income to
developing countries as can be witnessed by the lowering value of the US Dollar
compared to the Euro during 2003. At the same time fixed exchanged rates (e.g.
pegging the value of a national currency to the value of the US Dollar), which caused the
financial crisis in Asia, is still being used for instance by China that has been building up a
huge reserve in US Dollars, much to the dismay of the US. What kind of exchange rate
mechanism is the best?
Lack of information and understanding (models) to predict the next financial crisis,
even in Western countries. For instance, there is no internationally publicly available
information about all currency transactions of one particular bank.
New complex financial products, new technology, and new management techniques
accompanying continuous expansion abroad by consolidated financial firms still
poses unknown risks of financial instability and economic, social and environmental
effects. Recently, banks started to use complex financial products that transfer the credit
risks to others, for instance through securitization of (bad) loans and derivatives. This
makes it unclear who ends up taking the risk of bad debt (in any case not the bank that
provides the credit). Currently supervisors are afraid of unchecked, concentrated
accumulation of credit risk.
63
New important reforms such as the reform of the Basel Capital Accord (Basel II) take
much longer than foreseen to agree upon and are seen in the interest of large
international banks. The negative effects of Basel II on banks and provision of credit in
developing countries is still hardly heard (see above).
Many developing countries give priority on macro-economic and financial sound policies
that should keep investors happy, even if these investors are speculative or portfolio
investors. At the same time, social and environmental needs of the population are being
sacrificed.
Increasing importance of offshore centres
Offshore centres facilitate tax evasion and capital flight from developing countries through
low tax rates and lax monitoring rules. In 2003, the importance of offshore centre activity
increased with recorded claims on offshore centres totalling US$1.8 trillion in the second
quarter of 2003.
64
The huge budget, current account and trade deficit of the US is being financed by
issuing governmental bonds (mostly bought by Asian central banks such as Japan and
China), rules that make transferring money to the US attractive (foreigners do not need to
pay tax on interests in the US), and the strong investment banking and securities services
firms that dominate globally.
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Chapter 5 – Governmental regulations at the international level 155
Important role of the financial industry lobby
The successful lobbying of the financial industry plays an important role slowing down the
regulatory reforms of the international financial system. The financial sector regularly
dialogues with the authorities lobbying against new regulations and intervention. The
financial industry says that if the authorities create one rule, escape routes and new
problems will be created.65 The sector also argues that complying with a lot of regulations
is too expensive, which would cut deep into their profits.
The financial industry and investors are still hoping that, during the next financial crisis,
they will be able to much better defend their own (short term) interests without
international rules that would share the burden of a financial crisis.
The Institute for International Finance (IIF
66
) is an important lobby that represents the
major global financial firms and intervenes in many of the above-mentioned fora. The IIF
has openly argued against international measures that would prevent bailouts by
governments and would share the financial burden when governments cannot repay their
debt. In 1999, it declared that financial firms had the sole responsibility to increase
shareholder value and create profit while it was the responsibility of the government to
create financial stability and promote social objectives.
67
Such corporate lobbying influences and reinforces the neo-liberal thinking of governments
and financial authorities. As a result, many financial regulatory and supervisory authorities
in the Western countries are reluctant to introduce measures that would intervene in the
free market. The lack of support by the US often hinders new international measures to be
taken, for instance on the insolvency regulation for debtor states. The US position is
heavily influenced by the lobby of its financial sector industry that dominates world
markets in many sub-sectors of the financial services.
Even at the UN Conference on Finance for Development (Monterrey, Mexico, 2002) all
efforts to introduce issues of restructuring the financial system for development goals have
been undermined by the US and other Western countries.
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Chapter 5 – Governmental regulations at the international level 156
Critical issues
The lack of reform in the international financial architecture provides global
financial firms ways to escape sharing the burden of a financial crisis they might
help create. In case of a global financial crisis, the poor citizens and developing
countries are still too unprotected.
The current system of improving international coordination, cooperation and non-
binding standards seems so far to be working to avoid a world wide financial
crisis. However, the insurance industry and the stock market were causing
serious threats to financial stability in Western countries up to beginning 2004.
The pension crisis was still not resolved by the time of finalizing this report (March
2004). Developing countries in financial problems, such as Argentina, have not
been helped by the many foreign banks present in their country nor been brought
to quick economic recovery by the intergovernmental financial institutions.
5.5 Relation of financial services with auditors
Banks and other financial firms that provide financial services to companies rely heavily on
the financial reports of companies in order to assess the financial health of a company.
These financial reports are provided and checked by auditors, who thus play an important
basic role. There are, however, no auditing rules yet that are internationally enforceable
but there are international standards that are being adopted and implemented, sometimes
through national or EU law.
Since 2001, the accounting industry has been under much criticism for not being able to
detect fraud and other practices that lead to the financial collapse of multinationals such
as Enron and Parmalat. For instance, based on the wrong public financial reports from
accountants about Parmalat, some 20 investment banks were involved in 40 bond issues.
They raised around $ 9 bn for Parmalat in 10 years from large and small investors. Those
who bought Parmalat bonds for covering their pension might never see their money
back.
68
Holders of Enron shares and bonds started a class action litigation because Citigroup
mislead investors and helped hide Enron’s debt. In June 2005, Enron agreed to pay $ 2
bn to settle the case.
As part of the efforts to create a European single market, the European Commission
aimed to make all 7 000 firms listed in European exchanges use the same accounting
standards. The standards were designed by the International Accounting Standards Board
(see below) and are called the International Accounting Standards (IAS) & Financial
Reporting Standards (IFRS). In 2003 and 2004, there was much discussion about the 41
draft standards published by the IASB. Especially the IAS39 was heavily debated. This
rule covers accounting of financial instruments like derivatives. It states that those
instruments should be valued at ‘fair value’ (current value) instead of ‘historic value’. Since
fair values are much more volatile than historic ones, the balances of many financial firms
would also show much more volatility.
69
Obviously, financial firms have heavily opposed
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Chapter 5 – Governmental regulations at the international level 157
the proposals. The EU financial industry put heavy pressure to make new reporting more
suitable to their interests.
70
From January 2005 onwards, use of the standards has been made obligatory.
International standard setting on accounting and auditing takes place at:
International Accounting Standards Board (IASB): The IASB is a privately funded
accounting standard setter based in London. Board members have a variety of functional
backgrounds from nine countries. They aim at developing a single set of high quality,
understandable and enforceable global accounting standards that require transparent and
comparable information in general financial statements. In addition, the board cooperates
with national accounting standard setters to achieve convergence in accounting standards
around the world. The IASB is responsible for developing and approving the International
Accounting Standards (IAS).
http://www.iasc.org.uk
International Auditing and Assurance Standards Board (IAASB): The IAASB is a
committee of the International Federation of Accountants (IFAC) that works to improve the
uniformity of auditing practices and related services throughout the world. Therefore, it
issues pronouncements on a variety of audit and assurance functions and promotes their
acceptance.
http://www.ifac.org
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5.6 Conclusions and critical issues
1. Standards not internationally binding
Different international financial bodies set standards to regulate and supervise the various
activities of the financial industry. They provide guidance for regulators and supervisors
who are encouraged to implement the standards at the national level.
The international financial standards are not legally binding by international law nor
enforced through international mechanisms. Adoption of the financial standards by
national financial authorities around the world depends on cooperation, exchange of
information, and 'peer pressure' or name and shame. The regulatory and supervisory
framework is therefore different in each country. At international level, there is no
minimum of binding rules that regulate all operations of international financial firms in all
countries.
Because the standards are not binding, some governments chose not to adopt high
standards to prevent tax evasion in order to encourage their financial industry and markets
to compete internationally. Such offshore centres manage 40% of the world's wealth.
2. Regulation and supervision of the consolidated financial industry is
insufficient
The current international and national supervision and regulatory mechanisms have not
devised a common view or comprehensive response to the swift developments of the
cross-category and cross-border consolidation by global financial firms. Mega
conglomerates, like Citigroup, are becoming too big to fail. Governments cannot afford to
let them collapse because the effects on the wider economy would be devastating, even
though the costs of intervention and insuring clients are high.
National coordination and integration of supervision on banking, insurance and securities
activities is still unsatisfactory in many countries to supervise cross-category
consolidation. Each country is setting up different systems and has different policies
towards consolidation, which hampers effective international coordination to handle
problems facing complex and internationally operating financial conglomerates.
At the international level, there is no oversight of all the transactions for each financial
mega conglomerate separately, which means that no one body can fully assess the risk of
such potentially volatile financial players. Even the Joint Forum, which was created
especially to deal with conglomerates, does not have an urgent strategy on cross-sectoral
and cross-border financial supervision and regulation. The current lack of cooperation
between home country authorities and developing countries supervisors might hamper a
comprehensive response across boarders to deal with a conglomerate collapse.
3. Too little too late
International financial bodies have improved cooperation between national supervisors
and regulators, especially among national bank supervisors as a result of the work of the
Basel Committee. However, they do not follow the speed of the financial industry
developments and expansion into developing country markets. Progress is too slow,
especially in the insurance sector. Some standards and guidelines have only been created
when the damage was already done by a major crises or corporate scandal (e.g. the
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Chapter 5 – Governmental regulations at the international level 159
Basel Core Principles, IOSCO on conflicts of interest). International banking statistics
have also improved after each crisis and financial instability threat.
At the same time, progress in strengthening the financial architecture has been bogged
down and stalled by the lobby of the major financial services sector, leaving the system
even more vulnerable.
4. Developing countries lack the right to be heard, but are expected to comply
Many international standard setting bodies have no or little participation from developing
countries, although 'emerging markets' are often consulted and targeted. The main
decisions about capital flows and stability of the financial markets are still taken by bodies
where developing countries have no real say (e.g. G-7, IMF) and where problems of
developing countries are not sufficiently addressed.
5. Supervisors and regulators fail to adequately deal with risk
The so-called independent regulatory and supervisory authorities are beginning to rely
heavily on the financial firm’s own risk management procedures. This trend will
dramatically increase when new, controversial, rules on assessing borrowers ('Basel II')
will be finalized (due by mid 2004).
6. The lack of political will to prevent any financial crisis happening
Complacent about the prospects of a new financial crisis, officials and financial experts are
reluctant to intervene in the market even if the consequences are grave for many who are
already poor. Supervisors and regulators are under constant pressure from the financial
industry and its lobby.
The international financial supervisory and regulatory bodies are ignoring the risks of too
swift increase in unequal and unfair competition between foreign and domestic financial
firms due to liberalisation of financial services. The negative consequences cannot always
been dealt with through national regulation and supervision.
7. Civil society concerns ignored
The financial industry’s powerful voice heard at the international standard setting bodies
contrasts dramatically with the voice of civil society groups, which is barely, if ever, heard.
The work of international supervisory and regulatory bodies is not transparent and to date
has no system to involve all stakeholders. Public debates do not precede important
decisions taken at those institutions.
Regulators and supervisors at international level have little interest in environmental or
social issues, but rather in “maintaining a stable financial environment“ and avoiding
bankruptcies. Drafting of new banking supervision rules ('Basel II') did not incorporate risk
assessment from a sustainable development perspective. The many international fora
dealing with financial instability seem to be hugely underestimating the risks and costs
from environmental degradation, climate change and unfair globalisation that marginalizes
the poor.
Consequently, there are no international regulations that compel the financial industry to
support international agreements to eradicate poverty, and to promote sustainable
development and corporate social responsibility. No wonder there is not enough money
for sustainable development and CSR issues; all mainstream financial instruments have
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Chapter 5 – Governmental regulations at the international level 160
no binding obligation to prioritise sustainability: not in savings, credit, investments, or
insurance.
8. International financial bodies need to widen their scope
Leaving the negative social and environmental effects of international financial sector
consolidation and competition to national legislators and supervisors to deal with, is
inappropriate. Protecting consumers, marginalized people and the environment becomes
too complex and too costly, especially for many developing countries. International
competition might put pressure on governments not to introduce new high standards.
Moreover, many financial firms still see it as the responsibility of governments to achieve
financial stability and societal objectives, while they prioritise profit making and increasing
shareholder value. Current international financial operations and competition require
international financial bodies and free trade negotiators (see chapter 6) to tackle the
problems collectively. Financial authorities could do a lot at national and international level
to redirect financial flows towards more sustainable activities through for instance
71
:
new regulations on risk assessment, access and quality of services, and
obligations to report and inform about ethical policies;
new rights and obligations for investors, investment managers, governmental
financing institutions and shareholders;
tax incentives;
subsidies and other policies to promote sustainable financial products;
radical eradication of tax havens and bank secrecy,
more leeway for alternative financing schemes.
Civil society groups will have to find new ways to dialogue with international regulatory
and supervisory bodies in order to widen the latter's scope. They will also have to raise
awareness among the public about these complex issues to boost public debates and
support.
9. This report does not cover the many alternatives that have been conceived and
developed in order to avoid the problems of the corporate driven financial sector. These
alternative money systems are often used in times of crisis, as in Argentina, when
authorities have failed, money is scarce and credit once offered by financial firms has
dried up.
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5.7 Sustainability and Accountability in the Financial
Services Sector Regulatory and public policy
recommendations
The following paper was released by Friends of the Earth – US concurrent with the launch
of the Collevecchio Declaration (January 2003). The Declaration calls on financial
institutions to support regulatory changes that make it more possible for the financial
sector to advance sustainability.
Governments can and must play a key role in creating public policies and regulatory
frameworks that increase the ability of the financial services sector to advance
sustainability. In addition, governments must also improve accountability from the financial
services sector itself, as a way of ensuring that financial institutions are responsive to the
needs and expectations of the public.
Increase the ability of financiers to advance sustainability
As market makers and allocators of capital, financial institutions have a unique role and
responsibility in advancing sustainability. Financiers can:
Integrate environmental and social objectives into their financial strategies;
Analyze the social, environmental, or development impact of potential
transactions;
Use their influence and price capital in ways that promote sustainable practices
among their clients and investments;
Proactively finance enterprises that reduce poverty, enhance equity and restore
the environment.
However, financial institutions are often limited in their ability to implement these practices
because of current laws, and because avoiding certain types of transactions can put
responsible financiers at a competitive disadvantage compared to their more
unscrupulous competitors. Also, faced with imperfect markets, financiers find it "cheap to
do bad things, and expensive to do good things" because the costs of environmental
degradation and ill public health are often externalized onto the general public. Such
barriers can only be overcome by governmental action.
A. Integrating environmental and social objectives into financial strategies
Governments can take the following actions to help financiers align environmental and
social objectives into financial strategies and decision-making:
Changing the definition of fiduciary responsibility: In many countries, strict
interpretations of "fiduciary duty" discourages investment managers and trustees
from examining the social, economic and environmental dimensions of their
investment choices. Regulators should clarify that consideration of environmental,
economic and social issues is not in violation of, and in fact could advance the
fulfilment of, fiduciary duty. Governments can also expand the definition of
fiduciary duty to include the broader well-being of beneficiaries.
Public investment policy: Government regulators should create socially and
environmentally responsible investment policies and objectives for public finance
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 162
agencies and governmental retirement funds. For example, public export credit
agencies should adhere to high universal environmental and social standards,
and require co-financiers (e.g. loan syndicate partners and recipients of loan
guarantees) to do the same.
B. Analyzing the social, environmental, or development impact of potential
transactions
In order to implement investment, credit, or underwriting policies that promote
sustainability, financiers must have access to information on a potential transaction's
social or environmental impact. In particular, investors need comparable and robust social
information for all companies their investing universe.
Corporate disclosure laws: Governments should implement corporate social and
environmental disclosure regulations in markets around the world. Environmental
and Labour Ministries should create disclosure laws that obligate companies to
report data such as toxic releases, or worker health and safety data. For example,
in the United States, the Community Right to Know Act requires companies to
disclose toxic releases in a national Toxic Release Inventory.
Securities disclosure laws: National securities disclosure laws should require
reporting of material environmental, social and other corporate responsibility data.
For example, France currently requires disclosure of key environmental and
worker health and safety data in company annual reports.
Protection of civil rights: In order to perform adequate due diligence about the
social, environmental, or economic impacts of a potential transaction, financial
institutions often rely on civil society organizations as a source of information,
particularly in markets where disclosure regulations are poor. Therefore,
governments should support the preservation and promotion of civil and political
rights and freedoms around the world, particularly in developing countries.
International securities and accounting standards: The International Accounting
Standards Board and the International Organization of Securities Commissions
are currently working to harmonize corporate accounting and disclosure
standards across major markets. The IASB and IOSCO should ensure that best
practice in environmental and social financial accounting are promoted.
C. Using influence and pricing capital in ways that promote sustainable
practices among their clients and investments
The following public policies could increase the ability of financiers to use their unique role
as company shareholders and providers of capital in ways that promote sustainability:
Shareholder rights laws: Shareholder rights are in part defined by state or national
securities and/or company laws, which delineate the requirements for filing
shareholder proposals for both domestic and foreign investors, including topics
which are considered appropriate for shareholder action. For example, securities
laws in the United States provide relatively strong rights to investors by allowing
smaller shareholders to submit proposals, and by providing a degree of
supervision from the Securities and Exchange Commission when companies and
shareholders disagree about the appropriateness of a proposal.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 163
Incentives for sustainability: Regulators can create incentives for financial
institutions to capitalize environmentally/ social beneficial enterprises, and for
activities that generate income for the poorest. For example, the Netherlands has
introduced tax-free green funds (exempt from interest and dividend income tax) to
encourage Dutch citizens to invest in environmentally beneficial projects. Other
incentives could include giving banks a small degree of flexibility in their capital
adequacy requirements in return for prioritizing sustainable investments. The new
Basel Capital Accord ("Basel II") could also integrate sustainability factors into its
new methodology for evaluating banks' risk.
D. Proactively financing enterprises that reduce poverty, enhance equity and
restore the environment
Financiers often find it difficult to practice "community investing," financing enterprises that
reduce poverty, enhance equity and/or restore the environment. For example, financiers
can provide direct financing for socially and environmentally sustainable ventures,
purchase debt instruments in community development or micro-enterprise loan funds, or
finance low-income housing, small, women- or minority-owned businesses.
Bank regulation: Requiring commercial banks to lend to economically distressed
areas may help create markets, institutions and financial products that promote
community investing. United States example: The US's Community Re-
Investment Act requires commercial banks to target a certain portion of their
portfolio to investment opportunities in the bank's local economy, especially those
consumers that are historically disenfranchised. Banks are also ranked on their
compliance with the Act. The CRA has helped create an entire sub-sector of
community development financial institutions in the United States, which
specialize in providing access to capital and credit to low-income and distressed
communities. Similar regulations could also be applied to investors such as
collective investment schemes.
Protect community investing from trade agreements: Common trade-related
investment measures may harm the existence or effectiveness of community
development financial institutions. For example, provisions for "national
treatment" forbid governments from establishing or maintaining some investment
preferences to promote development in impoverished or minority areas. The
"national treatment" provision could nullify banking laws in the Philippines that
reserve rural banking services to indigenous financial institutions, which often
have particular capacities to serve the rural poor. Similarly, the US's Community
Re-investment Act conditions the opening of new bank branches on a company's
community re-investment record; this could be challenged under the investment
agreements to the WTO.
Capitalize community investment vehicles: National and state governments can
help capitalize community development financial institutions. For example, in the
US, the Community Development Banking and Financial Institutions Act of 1994
created a fund to promote economic revitalization and community development by
investing in and assisting community investment financial institutions through
equity investments, capital grants, loans and technical assistance.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 164
E. Minimizing Externalities and Market Distortions
In many cases, financiers are limited in their ability to shift their portfolios in ways that
capitalize enterprises with superior environmental or social performance because those
opportunities are not competitive given current market distortions.
Stronger and better enforcement of environmental and social laws: Where there
are lax or weak enforcement of environmental and social laws, there are fewer
monetary sanctions or impacts for companies with poor social and/or
environmental performance. Strong and well-enforced environmental and social
laws can help send the right market signals to investors.
Provide the right financial incentives: Aligning governmental subsidies,
procurement and tax policy to create financial rewards for responsible corporate
behaviour/ activities and disincentives for environmentally or socially harmful
corporate behaviour/activities can help the stock market reflect the bottom-line
benefits of corporate social responsibility. However, the ability of governments to
align procurement policies with environmental, social or other public policy
objectives may run afoul of "expropriation" provisions in international trade
agreements.
Create market imperatives: Government policies and sectoral objectives often
create markets in and of themselves. For example, in Germany, France and other
European countries, national authorities have committed obtain a certain
percentage of its country's energy from renewable sources. Such targets and
timetables create market imperatives that enhance the ability of financiers to set
and meet their own goals for shifting their energy portfolio into more renewable
investments.
F. Governance and Accountability in the Financial Services Sector
Currently, financial institutions are not held accountable for the downstream
environmental, social and public health impacts of the transactions they finance. Similarly
on the "upstream" side, small savers rarely have a to have a voice in the investment,
credit, and underwriting practices of the institutions that manage their savings and
investments.
Increase lender liability: In most countries, lenders generally are not held liable for
the environmental and social impacts caused by client misconduct. However, as
long as lenders remain financially shielded from the environmental and social
liabilities of their corporate clients, they will not fully value environmental and
social issues when performing their due diligence and pricing capital.
Crack down on predatory lending: In some markets, financial institutions engage
in "predatory lending" practices which banks aggressively sell inappropriate loans
designed to exploit vulnerable and unsophisticated borrowers. Regulators should
pass and enforce strict laws designed to abolish such exploitation and sanction
predatory lenders.
Disclosure in and of investment products: In order to inform consumers in their
choice of managed investment products, consumers need to know the ethical
policies and impacts of such funds. Laws requiring the disclosure of a fund's
ethical investment policies, proxy voting policies and practices, and even portfolio
holdings can assist consumers in choosing or benchmarking investment products.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 165
In the United Kingdom, recent law requires pension funds to disclose their ethical
investment policies and practices, if any.
Democratizing investment funds: Governments should promote greater
democracy in investment funds, including governance practices that provide for
better participation of fund participants or beneficiaries. For example, new laws
could oblige pension funds to elect a portion of their trustees from among their
beneficiaries, or require mutual funds to integrate participant input into proxy
voting policies.
Contact: Michelle Chan-Fishel, Friends of the Earth – US; [email protected]
1
Group of Ten, Report on consolidation in the financial sector, January 2001, p. 3.
2
H. Onno Ruding, The transformation of the financial services industry, Financial Stability Institute (Bank
for International Settlements), Occasional paper nr 2, March 2002, p.17 -22.
3
P. Norman, An EU call for transatlantic dialogue, in FTfm, 8 December 2003.
4
See R. Pozen, M. Draghi, A duet to mend markets and heal the rifts, in FT, 7 November 2003.
5
See for instance: C. Kirkpatric, Finance matters - Financial liberalisation: too much too soon?, id21
insights, nr 40, March 2002 (www.id21.org/insights/)
6
H. Onno Ruding, The transformation of the financial services industry, Financial Stability Institute (Bank
for International Settlements), Occasional paper nr 2, March 2002, p. 18.
7
S. Jung-a, KDB to lead joint takeover of LG Card, in FT, 3-4 January 2004.
8
See for instance J. Chaffin, A Michaels, Donaldson warns against turf wars, in FT, 10 September 2003
9
According to BIS (BIS paper nr. 16), offshore centres are: Aruba, Bahamas, Bahrain, Barbados,
Bermuda, Cayman Islands, Hong Kong, Lebanon, Macau SAR, Mauritius, Netherlands Antilles,
Panama, Singapore, Vanuatu; according to other sources and institutions, Switzerland, and Jersey and
other UK small island tax havens are also described as offshore centres.
10
BIS, The international banking market, in Quarterly review, December 2003, p. 16.
11
T. Catan, S. fidler, Swiss court convicts Abacha launderer, in FT, 22 December 2003.
12
Friends of the Earth - US, Sustainability and Accountability in the Financial Services Sector -
Regulatory and public policy recommendations, paper was released by Friends of the Earth - US,
Davos, January 2003.
13
For instance: investment banks can also trade securities in competition against stock exchanges
14
P. Norman, Parmalat changes mood in Brussels, in FTfm, 9 February 2004.
15
Anguilla, Antigua and Barbuda, Dominica, Grenada, Montserrat, St Kitts-Nevis, St Lucia, St Vincent
and the Grenadines, Turks and Caicos islands.
16
Information for this overview is mostly taken from the overview made by the Financial Stability Forum
(www.fsforum.org)
17
For more information see: www.bis.org
18
The list of members are: Algeria, Argentina, Australia, Austria, Belgium, Bosnia and Herzegovina,
Brazil, Bulgaria, Canada, Chile, China, Croatia, the Czech Republic, Denmark, Estonia, Finland,
France, Germany, Greece, Hong Kong SAR, Hungary, Iceland, India, Indonesia, Ireland, Israel, Italy,
Japan, Korea, Latvia, Lithuania, the Republic of Macedonia, Malaysia, Mexico, the Netherlands, New
Zealand, Norway, the Philippines, Poland, Portugal, Romania, Russia, Saudi Arabia, Singapore,
Slovakia, Slovenia, South Africa, Spain, Sweden, Switzerland, Thailand, Turkey, the United Kingdom
and the United States, plus the European Central Bank.
19
The 13 countries are: Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands,
Spain, Sweden, Switzerland, United Kingdom, and United States.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 166
20
The "Principles for the supervision of banks' foreign establishments" of May 1983 replaced the
Concordat's text of 1975.
21
IMF, Managing Risks to the International Banking System, in Finance and development,
December1996, p. 26; see N. Tair, BCCI ‘tragedy’ awaits long run, in FT, 12 January 2004: The UK
supervisors are in 2004 being taken to the court more than 10 years after BCCI collapsed.
22
"Information flow between banking supervision authorities", April 1990: produced by the Basel
Committee in collaboration with the Offshore Group on Banking Supervision.
23
IMF, Managing Risks to the International Banking System, in Finance and development,
December1996, p. 26-27.
24
See for instance M. Vander Stichele, De toenemende rol van banken in het financiële systeem,
October 2000, p. 12.
25
A. Persaud, The Basel plan must get back to market basics, letter to the Editor of the FT, 3 September
2003.
26
C. Pretzlick, Fed tries to safeguard Balse bank reform plan, in FT, 3 December 2003.
27
Basel Committee, Basel Committee Publications No. 109, July 2004
28
Martina Metzger, Basel II - Benefits for Developing Countries, BIF Working Paper Nr. 2, 2004.
29
BIS, High-level principles for cross-border implementation of the new Basel Capital Accord, press
release, 18 August 2003; see “The Set of principles for cross-border application of the New Accord”
(BIS, August 2003).
30
There are many critiques being written about the Basel II draft; they are mainly based on arguments
put forward by M. Metzger, Basel II - Benefits for developing countries?, speech given at WEED
conference, Berlin 29 November 2003; S. Griffith-Jones, How to prevent the new Basel Capital Accord
harming developing countries?, paper presented at the IMF-World Bank Annual Meetings at Dubai in
September 2003.
31
Griffith-Jones, Melanie, Miguel Segoviano & Stephen Spratt (2004) CAD3 and Developing Countries:
the Potential Impact of Diversification Effects on International Lending Patterns and Pro-cyclicality,
through http://www.ids.ac.uk/ids/global/Finance/pdfs/SGJCAD3Submission.pdf
32
See for instance M. Vander Stichele, De toenemende rol van banken in het financiële systeem,
October 2000, p. 41.
33
See for example Harald Benink, Are Basel II’s pillars strong enough?, in The Banker, 1
st
of july 2004,
through
http://www.thebanker.com/news/fullstory.php/aid/1690/Are_Basel_II%92s_pillars_strong_enough_.html
34
Griffith-Jones, Stephany & Spratt, Stephen, “Will the proposed Basel Capital Accord have a net
negative effect on developing countries ?”, mimeo, Institute of Development Studies, University of
Sussex, Brighton (via: http://www.jubileeplus.org/analysis/articles/griffith_jones_Basel_capital.htm)
35
See for example Andrew Cornford, A review of comments…precieze verwijzing??
36
Basel Committee, Consultative document - The New Basel Capital Accord, April 2003.
37
A. Persaud, The Basel plan must get back to market basics, in FT, 3 September 2003.
38
For information see: http://www.iaisweb.org
39
IAIS, Credit risk transfer between insurance, banking and other financial sectors, Press release, 7 April
2003.
40
Most information from : http://www.iosco.org
41
Basel Committee on Banking Supervision, Recommendations for public disclosure of trading and
derivatives activities of banks and securities firms, Basel committee Publications, nr. 60, October 1999.
42
IOSCO, The Technnical Committee of IOSCO today issued a Statement of Principles to guide
regulators and other s in addressing the conflicts of interest securities analysts may face, press
release, IOSCO, 25 September 2003.
43
Financial Stability Forum, Statement by Roger W. Ferguson, JR., Chairman of the Financial Stability
Forum, International Monetary and Financial Meeting, 21 September 2003.
44
Andrew Parker, Watchdogs seek better assistance, FT. December 13
th
2004
45
See for instance: Basel Committee, IOSCO, IAIS, Joint Forum releases cross-sectoral reports, press
release, 7 November 2001; www.iaisweb.org.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 167
46
See for instance an extensive study done on bank regulation and supervision in 107 countries to
assess the relationship between specific regulatory and supervisory practices and banking sector
development and fragility: J. Barth, G. Caprio, Jr. and R. Levine, Bank regulation and supervision: what
works best?, January 2002.
47
See box: Scandals by major financial firms in chapter 1.
48
Group of Ten, Report on consolidation in the financial sector, January 2001, p. 3-6.
49
Wholesale activities such as payment and settlement systems.
50
Public disclosures by banks: results of the 2001 disclosure survey, in Basel committee publications, nr
97, May 2003.
51
See Financial Stability Forum
(http://www.fsforum.org/compendium/how_is_the_compendium_organised.html)
52
Information for this overview is taken from the overview made by the Financial Stability Forum
(www.fsforum.org) and the websites mentioned except if otherwise stated.
53
Australia, Canada, France, Germany, Hong Kong, Italy, Japan, Netherlands, Singapore, United
Kingdom, United States; the Financial Stability Forum members also often meet with authorities from
non-member countries in Central and Eastern Europe, Latin America and Asia.
54
http://www.bis.org/cgfs/index.htm
55
http://www.imf.org
56
A. Krosta, F. Schmid, IMG urges change in German bank rules, FT, 16 September 2003.
57
http://www.oecd.org
58
The OECD has 30 member countries, most developed economies with market economies.
59
See Bank profitability - Financial statements of banks: Edition 2002, at www.oecd.org > finance and
investment > documentation > documents-statistics, data and indicators > bank profitability - Financial
statement of banks: Edition 2002.
60
http://www1.oecd.org/fatf/
61
Tax havens seek WTO intervention, in FT, 2 October, 2000.
62
Bankentoezicht minder streng na aanslagen VS, in Het Financieele Dagblad, 10 December 2001.
63
Financial Stability Forum, Statement by Roger W. Ferguson, JR., Chairman of the Financial Stability
Forum, International Monetary and Financial Meeting, 21 September 2003.
64
BIS, The international banking market, in Quarterly review, December 2003, p. 16
65
See for instance: Under the regulatory yoke, in FTfm, 19 January 2004, p. 28; For an overview of
some lobby groups, see annex to this report
66
See: www.iif.com
67
M. Vander Stichele, De toenemende rol van banken in het financiële systeem, SOMO, October 2000,
p. 12,14-15.
68
J. fuller, No one attempted Parmalat jigsaw, in FTfm, 19 January 2004, p. 6.
69
The Economist, Accounting Standards. A question of measurement, October 23
rd
2004.
70
See for instance: A. Parker, IASB to ease draft rules for EU banks, in FT, 21 August 2003.
71
For a comprehensive set of recommendations, see below: Friends of the Earth - US, Sustainability and
accountability in the financial services sector, declaration released in January 2003.
(http://www.foe.org/camps/intl/financialregs.html)
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 168
Chapter 6
Trade in financial services:
liberalisation in the GATS Agreement
and insufficient assessment of the
risks
The General Agreement on Trade in Services (GATS) is the only agreement at the
international level which regulates and liberalises trade in financial services as well as
investment of financial services providers. The GATS agreement was negotiated in the
Uruguay Round (1986-1994) and since 1995 had to be applied by all the WTO members
(148 by mid 2005). GATS is part of the World Trade Organisation (WTO), including the
WTO's decision-making and dispute settlement structures. Liberalisation of financial
services is also dealt with in many regional and bilateral trade agreements but will not be
analysed in this chapter; many points of analysis might however be the same.
The general principles and rules of the GATS agreement also apply to financial services.
In addition, the GATS agreement has special instruments that only relate to financial
services, as explained below.
This chapter also includes an analysis of the risks that financial service liberalisation and
GATS rules entail for financial instability and wider society issues in developing countries.
These risks are not widely or publicly discussed in the current GATS negotiations and
brushed aside by Western financial services negotiators.
6.1 The GATS instruments to liberalise financial services
The GATS agreement has different ways to liberalise services, in casu financial services.
First, it is necessary to clarify what kind of trade in (financial) services is covered by
GATS, because it includes investment by foreign (financial) firms.
6.1.1 The rules of the GATS Agreement
6.1.1.1 The definitions of “trade in services”
According to the GATS agreement, trade in services can take different forms:
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 169
Mode 1: cross-border movement of the service or "cross border trade": e.g. a
financial firm established abroad is allowed to provide services to nationals such
as banks deposits via internet banking.
Mode 2: cross-border movement of the service consumer or "consumption
abroad": e.g. an Indonesian art trader is allowed to take a loan from a bank based
in the Netherlands.
Mode 3: cross-border movement of the corporate service provider through
investments or "commercial presence": e.g. a country allows foreign banks to buy
up domestic banks or to open up branches in its territory.
Mode 4: "cross-border movement of persons": e.g. a Brazilian manager of a
Dutch bank is allowed to work at the offices of the Dutch bank in Amsterdam or
New York.
6.1.1.2 Liberalisation of services under GATS
One part of the GATS agreement deals particularly with liberalisation of (financial)
services, i.e. opening up markets to allow services and services providers to enter the
country. A country can decide which (sub)sectors it liberalises, or "makes commitments"
in, by adding them to its GATS list ("schedule"). For instance, a country can fully or partly
liberalise its financial services under GATS. A country's GATS schedule specifies which
(financial) sub-services are liberalised for which "modes", and can include exemptions to
some GATS rules. A country can decide not to make a commitment in financial services by
not adding financial services to the schedule.
The decision to open up, or not, certain services sectors is an important part of the GATS
negotiations. A country receives "requests" from other WTO members, i.e. lists of services
for which other countries demand market opening. A country then replies with an "offer", a
list of services it is prepared to liberalise. Subsequently bilateral secret negotiations follow
in which countries bargain between each other's offers and requests. Although this
process is supposed to be a give-and-take exercise, this is in practice often not the case
because power games and arm-twisting happen during the negotiations. At the end of the
bilateral negotiations between the many WTO members, each country includes a
schedule of services for which it grants new market openings in the GATS agreement and
which is valid for all WTO members (Most Favoured Nation Principle).
6.1.1.3 The GATS rules and obligations that apply to financial services
The GATS agreement is based on the assumption that many barriers to trade in services
and limitations on the operation of foreign services' firms come from government
regulations, measures and administrative decisions. The GATS agreement has a set of
rules and obligations that governments have to implement to allow foreign service
providers to operate more freely. It includes the following disciplines, which also apply to
financial services:
1. General obligations that a country has to implement even if it has not liberalised any
(financial) services under GATS:
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Chapter 6 – Trade in financial services 170
treating all foreign (financial) services equally (Most Favoured Nation /
MFN) (Art. II);
transparency: openness and notification of all measures and new laws on
(financial) services to other WTO members (Art. III);
facilitate the increasing participation of developing countries in world
trade in services through negotiating specific commitments and
establishment of contact points by developed countries (Art. IV).
2. Specific obligations applying to (financial) services that have been liberalised, i.e.
committed in the GATS schedule of each WTO member:
due treatment of foreign services suppliers when taking administrative
measures or giving authorization to supply a (financial) service (Art.
VI.1.,2.,3.);
ensure that standards, licensing and qualification requirements do not
constitute a barrier to trade (Art. VI.4.,5.): more disciplines need to be
negotiated;
no restrictions on international payments for current transactions related
to committed (financial) services (Art. XI), except in case of balance of
payment problems (Art. XII);
no measures that limit the operation or ownership of (financial) services
e.g. limitation on the number of branches (market access obligations in
Art. XVI);
equal treatment of foreign and national financial service providers
(national treatment according to Art. XVII);
a GATS commitment to liberalize can only be reversed by a country after
three years and in addition, the WTO trading partners can request
compensation that needs to be negotiated (Art. XXI).
3. Continuous liberalisation negotiations
Under Art. XIX, the WTO members agreed to periodically start new negotiations to further
liberalise the service sectors of each country, while respecting national policies. The first
such negotiations started in 2000 and have been included in the Doha Round of
negotiations (start November 2001). However, the negotiations started without duly
implementing Art. XIX.3. that calls for carrying out an assessment of the experience in
trade in services.
During the current GATS negotiations, leaked "requests" from the EU make clear that
market opening mostly means eliminating national laws and regulations that are seen as
barriers to trade or in fact just a barrier to make maximum profit by the foreign (financial)
services firms.
Regarding GATS rules, difficult negotiations are still underway on domestic regulation (Art.
VI.4.), emergency safeguard measures (Art. X), subsidies that can be allowed or not (Art.
XV), and procurement of services by and for governments (Art. XIII). Developed and
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 171
developing countries have opposing interests, which constantly delays the negotiations
and agreed deadlines.
6.1.2 The Annex on Financial Services
The Annex on Financial Services is fully part of the GATS agreement and provides some
specification on how authorities can take measures relating to financial services. In
addition, the Annex (Art. 5.) provides a non-exhaustive list of insurance, banking and other
financial services that are subject to GATS rules and commitments.
The Annex describes which "services supplied in the exercise of governmental authority"
are exempted from the GATS agreement (Art. 1), such as activities by central banks or by
the public retirement systems.
Prudential carve-out
Art. 2 of the Annex specifies that WTO members can take measures for prudential
reasons such as protecting investors and depositors, and ensuring the stability and
integrity of the financial system even if such measures do not conform with GATS rules.
However, prudential measures should not be abused to circumvent GATS rules nor
commitments made under GATS.
In case of a financial services trade dispute, the WTO panel is assumed to have the
necessary financial expertise.
The Annex (Art. 3) specifies how countries can make agreements to accept each other's
prudential measures.
6.1.3 The GATS agreement includes a model for swift
liberalisation
The financial services have received a special separate text belonging to the GATS
agreement to promote their quick and full liberalisation through several means: The
Understanding on Commitments in Financial Services. If a WTO member agrees to open
up its financial services according to the 'Understanding', then it has to make the
commitments as described below, with a right to schedule exemptions. All industrialized
countries have accepted the Understanding as the basis of their commitments and see it
as a minimum for others, but only very few developing and emerging market countries
have joined in. In total only 30 countries have opened up their financial services according
to this Understanding.
A model for extensive market access
The Understanding (Part B.) provides a set of market openings to be applied by WTO
members that implement the Understanding. Such market opening relates to:
cross-border trade (mode 1) for a few insurance services and for services in support of
banking and investment (e.g. advice),
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 172
the right of consumers to purchase abroad (mode 2) financial services mentioned for
mode 1 as well as all other banking or financial services,
the right of establishment and expansion by all foreign service financial providers (mode
3), including through acquisitions, and the right of governments to impose some
conditions,
the temporary presence of managers and specialists in financial services (mode 4).
Moreover, any new conditions to the above market opening may not be more restrictive
than those already existing (standstill in restrictions - Part A.).
Members can include this set of market opening in their schedule or still choose to make
up their own GATS schedule in which they open up some (financial) services to foreign
suppliers.
Erosion of exemptions from GATS rules
The Understanding (Part. B.1.- 2.) invites WTO members not to apply exemptions which
are allowed by the GATS agreement to financial services! This means that regulations
about procurement of financial services by public entities should be in conformity with the
principles of national treatment and most favoured nation while this is not necessary
according to Art. XIII. The Understanding also requires each WTO member to list in its
schedule monopoly rights provided to financial services and strive to eliminate them (while
they are allowed under GATS Art. VIII) as well as list and eliminate financial activities
conducted by a public entity for the account of the government (allowed in the Annex on
Financial Services Art. 1.(b).(iii)).
Eliminating all barriers to trade in financial services
The Understanding (Part B.10.) also requires members to remove any obstacle to foreign
financial services that remains even if all the provisions of the GATS agreement have
been respected. Following on, the Understanding provides guarantees that
foreign financial service suppliers:
are permitted to introduce any new financial service (Part B.7.),
are not hindered in the transfer of information (Part B.8.),
have access to payment and clearing systems operated by public entities (except
lender of last resort facilities) (Part C.).
Foreign financial companies see the lack of such guarantees as (non-tariff) barriers to
their trade.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 173
6.1.4 After the Uruguay Round: the Fifth Protocol to the
GATS
At the end of the negotiations of the GATS agreement in 1994, some WTO members and
especially the VS (read: its financial lobby) were not satisfied with the commitments made
by WTO members on financial services. It was decided to continue the negotiations on
financial services specifically, which lasted until the end of 1997. The Fifth Protocol to the
General Agreement on Trade in Services contains the lists of countries that agreed upon
more market openings for financial services than in 1994. Although the Protocol entered
into operation in 1999, several members have postponed their acceptance of the protocol,
amongst others Brazil.
6.2 Assessing the risks for developing countries
6.2.1 Liberalisation of financial services under GATS
6.2.1.1 GATS negotiations reinforce the interests of Western financial firms
The opening of markets for financial firms from the US and other Western countries has
been one of the key forces behind the GATS negotiations during the Uruguay Round
(1986-1994). Under pressure from its financial lobby, the US was unwilling to give most
favoured nation (MFN) status to countries that did not open for US financial services, one
of the reasons why exceptions to MFN were allowed. The US dissatisfaction with financial
services market openings during the Uruguay Round lead to complementary GATS
negotiations on financial services. The latter were concluded at the end of 1997 (see
above: Fifth Protocol) after the US had been pushing much harder for market opening
than the EU. The lobby of the world's major financial firms was strongly present behind the
scenes and was even involved at the highest level through the Financial Leaders Group.
1
Afterwards, the EU negotiator, who had phoned them from the negotiating room according
to a lobbyist, openly praised the EU financial lobbyists.
Especially the emerging market countries were under pressure to open up their markets
even though the Asian financial crisis had already erupted in 1997. The WTO and others
argued that liberalisation of financial services would not enhance the financial crisis but
rather strengthen the 'weak' financial sector in crisis-stricken countries. Some observers
claim that additional market opening was forced by the US in return of financial packages
to help countries survive the financial crisis.
Again during the GATS negotiations that started in 2000, the basic negotiation position of
the EU and other Western countries is to aggressively open up more markets for their
financial services. The leaked requests of the EU to developing countries
2
read like a wish
list of European financial firms by which all governmental measures that hamper their
expansion and profit making would be removed. For example, a recurring demand in the
EU requests is that developing countries give up their restrictions on full foreign ownership
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 174
of banks such as compulsory joint ventures. The EU argument is that full ownership
results in better allocation of resources than in financial firms that must involve local
elements. However, increased full foreign ownership of banks raises many issues, as
explained below. The ultimate examples of industry lobbying are where the leaked
requests state "EU industry raises this issue" (e.g. in request to Thailand).
The financial services in 'emerging markets' and higher-income developing countries are
again a major target of the EU requests, although the EU has also addressed financial
service requests to 20 least developed countries and 30 low-income countries.
3
The US
strategy is presumably the same or even more aggressive but details remained secret.
The financial market of Russia, which is negotiating to become a member of the WTO, is
an important target of the American insurance industry. The American Council of Life
Insurers
4
stated that it would oppose Russia's accession unless Russia guarantees
market access to foreign life insurance companies. Developing countries have little
financial services to export so that the market opening demands of the Western financial
firms dominate the current financial services negotiations.
The liberalisation negotiations on financial services in GATS fit neatly with the
consolidation strategy of the world top financial industry (see chapter 2) and will reinforce
it. The GATS negotiations do not only provide the financial industry with access to more
markets and improved chances of full ownership of banks worldwide through mergers and
acquisitions. The GATS agreement also guarantees that this liberalisation is difficult to
reverse (Art. XXI) and that national measures that hamper profit making and consolidation
are being restricted (e.g. Art. VI, XVI and XVII). The 'Understanding on Commitments in
Financial Services' (see above) clearly underpins the interest of financial conglomerates
that are engaged in cross-border and cross-sector consolidation. The EU requests many
developing countries to open up according to this 'Understanding'.
6.2.1.2 Few instruments to deal with increasing concentration
As explained in chapter 2, some sub-sectors of financial services have a high level of
concentration with a few companies dominating world wide, such as in investment
banking, derivative services and rating agencies. Financial firms from emerging markets
and developing countries have no capacity to compete in those concentrated sectors at
the national or international level. In five East Asian countries, American and European
banks have been able to dominate in capital market services
5
(incl. investment banking)
and large syndicated loans.
6
When opening up these financial sub-sectors, WTO members have to be aware that
foreign firms will easily dominate. However, it might be too costly for national authorities to
support the development of national service providers in these sectors.
Concentration of financial services leaves governments – which need private finance –
and customers with too little choice. It opens the way to abuse of economic and market
power such as tacit price-fixing and high prices that are detrimental to development.
Secret price-fixing occurs but seldom comes to light as happened in Germany by the
insurance companies
7
and in Kenya where a cartel of foreign banks fixed high interest
rates.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 175
The GATS agreement has only very weak instruments to tackle problems related to
concentration and consolidation (see also chapter 2). GATS Art. IX recognizes that
business practices may restrict competition and trade in services but does not contain real
competition policy measures. Only when restrictive business practices occur at the
national level by foreign service providers can the domestic authorities ask for
consultations. The home country should only give "sympathetic consideration" to such
requests and non-confidential information. Moreover, the negotiations on emergency
safeguard measures to protect the local (financial) services industry from being
overwhelmed by foreign services, are being opposed and constantly postponed by
Western countries.
Critical issues
How far will consolidation go?
Further liberalisation under GATS is likely to increase consolidation and
concentration. It is however not discussed up to what level consolidation will be
allowed at international level. Will supervisory authorities intervene in trade
policies when banks become too difficult to monitor and “too big to fail”? Financial
firms will argue that further consolidation is the most important strategy in current
international competition. In case the same few top financial firms will compete in
all countries and thus form a worldwide oligopoly, can WTO members reverse
their liberalisation under GATS without paying compensation?
6.2.1.3 The arguments behind liberalisation of financial services
In the literature
8
and in discussions, many arguments can be found in favour of, as well as
against presence of foreign banks.
The arguments put forward by those in favour of liberalisation are:
reduction in overhead expenses and profit-taking by domestic banks due to
increased competition by foreign banks;
increased efficiency and diversity of financial services;
spill-over effects of foreign bank entry, such as the introduction of new financial
services and of modern and more efficient banking techniques, and the
improvement of domestic bank management;
improvement in bank regulation and supervision due to the entry of new financial
service providers and new financial services;
less interference by governments in the financial sector, to cover up bad
practices;
training by foreign banks, resulting in more experienced personnel in the financial
sector of a country;
the presence of foreign banks stimulates domestic investment in the host
countries;
foreign banks may attract (other) foreign direct investments and enhance a
country’s access to international capital;
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 176
well capitalized foreign banks may be able and willing to keep lending to domestic
firms during adverse economic conditions, while domestic banks would probably
reduce the credit supply;
foreign bank entry leads to better lending terms (lower interest rates, lower fees,
longer maturities) for all but larger firms.
The arguments put forward for those opposing foreign entry are:
domestic banks are not able to cope with increased competition, and may stop
operating, which can cause disruptions and political concerns about increased
foreign control of the financial market;
trying to cope with increased competition from the foreign banks and
implementing new techniques may raise costs for local banks in the short term,
which they would then finance by raising their profit margins, in turn leading to
price increases for consumers;
foreign banks get higher interest margins;
foreign banks' entry into the market of loans to corporations does not decrease
the margins and profits in the personal loan market;
foreign banks will not provide additional credit during an economic downturn in a
host country;
foreign banks will leave the country when the profitability is too low, which can
undermine stability in financial services;
changes in economic conditions in the foreign bank’s home country may have a
negative effect on bank activity in the local market;
foreign banks only provide credit to large and often foreign-owned (multinational)
firms, and tend to lend less to small firms and poor consumers;
domestic supervisory and monetary authorities often fear that their influence on
banks’ behaviour may diminish as supervision of foreign banks' branches is done
by the authorities of the home country.
6.2.1.4 Experiences of financial services liberalisation in developing countries
The evidence of liberalisation of financial services in developing countries seems to be
mixed. The literature provides mainly evidence from banking and some few other financial
sub-sectors or from a particular perspective. Many data are missing to provide a full
picture. In order to guide negotiators, economic models do not exist to assess the full
impact of future financial services liberalisation. Moreover, no overall assessment of the
experience in trade in (financial) services was carried out as GATS Art. XIX.3. calls for.
From the literature and research done by SOMO, the experiences of developing countries
seem to be well reflected in the assessment of trade liberalisation in financial services
made by China
9
which included the following issues.
10
(a) Positive effects:
Improving efficiency, functioning and management
Foreign banks have been improving the functioning of the financial system in China: they
are promoting the competitiveness of domestic banks and bringing in new experience in
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 177
risk management, internal controlling, incentive mechanisms, business innovation and
accounting.
In Sub-Saharan Africa, experience of increased foreign participation in the domestic
banking sector to date has shown such benefits as improved quality, pricing and supply of
financial services and in risk management, accounting and transparency as well as
increased competition.
11
Especially in poorer developing countries where the banking
system is considered inefficient and unreliable, the entry of foreign banks is claimed to
make domestic banks more efficient and avoid the high economic cost of inefficiency that
prevent development, trade and investment.
12
Research findings differ whether domestic banking efficiency increases by a large number
of new foreign entrants or by (a few) new entrants with large market shares.
13
Increased access to foreign capital
In China, foreign financial firms have increased foreign capital inflows and the investment
environment has improved.
Introducing new financial services and innovations
Foreign financial services companies have provided more advanced services and financial
innovations to consumers in China. In insurance, a major US insurance group (American
International Group) introduced an insurance marketing system, stimulated the domestic
insurance market, strengthened the idea of customer-oriented service among Chinese
insurance companies, and promoted the development of the personal life insurance
market.
(b) Negative effects:
“Cherry picking”
China has experienced that domestic banks loose especially rich clients (“high end
consumers”) to foreign banks. Since such rich clients provide most of the profit for a bank
(according to Chinese statistics: 80% of the profits come from the richest 20% of the
clients), domestic banks are losing profitable clients and are left with the less profitable
ones. This can further undermine their capability to compete with foreign banks, which in
turn are not interested in serving poorer clients.
In Turkey, for instance, foreign banks have chosen aggressive strategies to only focus on
large lucrative clients (e.g. multinationals, governments) and projects (e.g. privatization).
14
In Sub-Saharan Africa and elsewhere (e.g. India), foreign firms use their financial power
and international status to focus on the most lucrative transactions and lure rich and
middle class customers. These findings confirm a case study of the Dutch bank ABN
Amro in Brazil, which showed that it was not more efficient than domestic banks which
had survived many financial crises but many people trusted its status as a foreign bank
which attracted richer people who were willing to pay more.
15
An important question is whether this cherry picking by foreign financial firms mobilizes
more domestic savings or rather increases capital flight.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 178
Undermining poverty eradication
This cherry picking and market segmentation is undermining poverty eradication (see
chapter 1) as foreign financial firms are hardly interested to expand their services to the
poor. As was researched in Kenya
16
, the situation is similar for foreign health insurance
companies. These companies tailor their services to the wealthy city-dwellers who are
already able to pay their hospital bills. They charge high premiums, unaffordable to poor
patients. They refuse to accept patients who suffer from illnesses such as HIV/AIDS. This
is in sharp contrast to the government’s public health insurance system, which is obligated
to accept all patients.
The recent situation in some Latin American economies also highlights the risk that
foreign banks will not offer their services to smaller clients like households and SME’s.
Especially in Mexico, where foreign banks control 85% of the total banking sector but
provide too little lending to local companies to stimulate economic growth. Politicians and
supervisors have expressed their doubts on the past decision to open their banking sector
up to foreign competition. Households and SME’s hardly have access to credit at
reasonable rates. The government is considering legislation that will make it mandatory for
banks to change their lending practices.
17
Critical issues
GATS 'flexibilities' not used
During the previous GATS negotiations, Kenya agreed to liberalise its financial
services without fully realizing that it was also subjecting the health insurance
sector to the GATS rules. Article XVI prohibits governments from taking six
specific kinds of measures to place limitations on companies, such as economic
needs tests and restrictions on the number of service suppliers. During the
negotiations, the Kenyan government could have reserved the right to impose a
universal service requirement for foreign insurers only, but did not do so. The
government can now require foreign companies to insure poor and vulnerable
(HIV-positive or terminal) patients only if it also sets the same requirement for
Kenya-based insurers, according to the GATS principle of non-discrimination and
national treatment (Article XVII). Whether countries will impose universal service
obligation is another matter, as it is considered to have an unfavourable impact on
the financial firms’ profitability and stability, and thus discourage investments.
18
Widening the gaps
In China, the imbalance of economic development between the eastern and western
regions is widening further as more foreign investments and their banking services flow to
the more developed eastern part of the country. Taiwan equally experienced that foreign
financial firms stayed in the capital areas and did not go to the non-profitable rural areas.
19
When foreign banks are easily dominating the most lucrative services as is the case in
South East Asia for investment banking and syndicated loans, domestic banks might
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 179
specialize in catering to the credit needs of small and medium-sized firms and
households. In such situation, liberalizing financial services may not result in the
proclaimed improvement of competitiveness and efficiency of the domestic financial
service industry through transfer of new sophisticated financial technologies.
Critical issues
Undermining lending to non wealthy borrowers
In case local banks do not survive the competition from large foreign banks, their
expertise and capacity to borrow to small producers and poorer households will
be lost. This can enhance the divide between small and rich producers, make
poverty eradication more difficult, and have an impact on the whole economy.
Widening the gender gap
If cherry-picking is common practice by foreign financial firms, it has also gender
implications in developing countries. Women constitute the majority of the poor
and are often very small producers or entrepreneurs. Although the female rate of
repayment of loans is high, their lack of collateral means that they often have to
rely on micro-credit systems for financing. If financial services liberalisation does
not provide them with better access to finance while larger entrepreneurs are
better financed, their fight against poverty might be undermined and the gender
gap increased.
The experience of 80 countries between 1988 and 1995 shows that foreign banks in
developing countries tend to have greater profits, higher net interest margins and higher
tax payments than domestic banks.
20
Critical issues
Transferring wealth from poor to rich countries
Foreign financial firms that make profits from richer clients in developing countries
and transfer that profit abroad, are thus transferring some of the wealth from
developing countries to the rich home countries. Moreover, Art. XI of GATS does
not allow restrictions on profit repatriation.
Brain drain from local to foreign banks
In China, domestic banks are losing many capable senior executives and key personnel.
This leads to a lack of experienced executives in domestic banks and further undermines
the swift development and improvement of these banks. Such experience contradicts the
argument that foreign presence of banks lead to transfer of know how.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 180
(c) Challenging problems
Swift expansion of foreign financial services
During the second half of the 1990s
21
, there has been a dramatic and very rapid increase
in foreign ownership of banks and foreign banking activities in many developing countries
and in China. Figures indicate
22
that the presence of banks from developed countries
increased:
by more than 59% in East Asian countries
23
between 1996 and 2001,
by 364% in Latin America
24
during the period 1996-2000, and
by 85% in Central and Eastern Europe
25
during 1996-2000.
In Tanzania, liberalisation for foreign banks increased their presence from 5% before 1980
(when policies where restrictive) to 76% in 2002.
The entrance of foreign insurance companies has also shown a dramatic expansion of
these companies in a short period of time in China.
It is difficult to establish whether the GATS agreement on financial services (1997) had an
influence on this large increase of presence of Western banks. There was a general trend
towards opening up financial sectors during that period -which was reflected in some
GATS schedules
26
- alongside the strategy of many internationally operating financial firms
towards global consolidation.
The EU (and US?) requests during the current GATS negotiations to eliminate restrictions
on full foreign ownership in small or poor developing countries can easily lead to
domination by foreign banks. What are the consequences for monetary and development
policy when foreign financial service providers control more than 75% of the banks, as is
the case of Tanzania, and more than 80% of private financial assets, as is the case of
Mexico?
Moreover, dominance by foreign banks makes these countries vulnerable to strategies of
financial conglomerates that leave the country when profits decline. This makes it more
difficult for the authorities to monitor the financial system.
Critical issues
Difficulties to keep up with the rapid changes
Rapid increase of foreign financial firms make it difficult for domestic financial
firms to meet the fierce competition, while the supervisory and regulatory
authorities have trouble keeping abreast of the developments and their risks.
Allocating more savings of developing countries to the rich countries?
Foreign financial conglomerates have more expertise on how to allocate domestic
savings and capital in Western investments than the domestic financial firms in
developing countries. It might be too costly for foreign financial service providers
to fully explore new investment opportunities in the host country. When
developing countries have liberalised their financial services and capital account,
more of their savings get allocated to the North (e.g. Northern company shares)
and not in domestic investments. In this way, domestic economic development
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 181
opportunities are lost and the global imbalance of capital allocation reinforced. As
more and more developing countries' banks are being privatised, governments
have fewer opportunities to prioritise the financing of domestic (service)
industries.
Little capacity to export financial services
GATS has also provided for China’s financial firms the opportunity to establish abroad, but
Chinese financial services lack the competitive edge (and still need a lot of restructuring)
to expand abroad to the extent that foreign financial services are capable of entering the
Chinese market. This adds to a deficit in services trade, and to balance-of-payments
problems.
In Africa, the insurance sector has so far remained underdeveloped and without the
necessary backing from governments. Lack of capacity and expertise has prevented the
sector from starting viable commercial relations among African countries and making them
fully prepared for international competition at home and on international markets.
27
Need for new regulatory and supervisory bodies
After opening up its financial services sector under GATS, China needed to introduce new
regulatory bodies for supervising the insurance and securities' sectors, alongside those
regulating and supervising the banking sector. This can strengthen the financial sector
and its stability. However, given the required swiftness, cost and expertise, many
developed and developing countries have not yet finalised their regulatory and supervisory
reforms (see chapter 5). Note that in the West, regulators and supervisors have come to
the conclusion that banking and insurance supervisory bodies are not adequate and need
to be integrated because financial firms increasingly integrate banking, insurance and
securities (see chapter 5: these reforms have not yet fully taken place in all developed
countries).
How much progress in efficiency?
In Sub-Saharan Africa, the presence of foreign banks increases loans by both domestic
and foreign banks, but the variability of the loan supply decreases. Foreign banks in Sub-
Saharan Africa do not necessarily have fewer bad performing loans nor are they better
capitalized than local banks – although better capitalization is often claimed as an
advantage they enjoy, making them more resistant to financial crises. Foreign banks can
out-compete locally owned banks in smaller economies because they can recover their
high set-up costs from profitable operations elsewhere.
28
The high presence of foreign banks Latin America
29
shows that the stimulus for domestic
banks to increase efficiency through lower overhead expenses and less profit taking only
works out in countries at the lower levels of economic development (e.g. Peru, Colombia,
Ecuador and Bolivia), but not for the more developed countries such as Brazil. Note that
“more efficiency” by local banks means “less profit”. Less profitability and greater
competition can avoid abuses but also lead to more risky lending practices by smaller
local banks.
30
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 182
Risks of financial instability
The risks of financial instability in developing countries resulting from financial services
liberalisation and GATS rules are being analyzed below as follows:
1. too little awareness that new financial services require new prudential measures
2. foreign financial services increase cross-border capital flows and financial instability
3. GATS articles advance cross-border capital flows and capital account liberalisation
4. GATS articles challenge measures to deal with destabilising capital flows
5. GATS articles undermine prudential measures and regulations domestic authorities
take
6. GATS articles affect the management of the financial industry and instability risks
6.2.2 The risks of financial instability in developing countries
While the GATS negotiations in financial services are about liberalisation of financial
services, they affect the national (de)regulation of financial markets and financial services,
as well as measures that manage large capital transactions ("capital account"
31
). The
latter two sets of measures are nonetheless the domain of finance authorities and affect
the financial stability and economic situation of a country, especially in developing
countries. The experience with the recent financial crises in Asia and Argentina has
indicated that capital account liberalisation has increased the risk of a financial crisis in
developing countries that failed to develop a strong regulatory and supervisory framework
prior to liberalisation. Foreign banks contribute to a financial crisis by using capital account
liberalisation for imprudent short-term lending policies and “herding behaviour”, and by
hoping –mostly successfully- that governments will support repayment of commercial
debt.
Developing countries have already expressed their concerns that market opening and
GATS rules might result in capital movements that create financial instability and affect
governments' decisions to institute prudential measures to avoid a financial crisis. The
devastating effects of a financial crisis should prioritize negotiators' attention to assess the
risks and address the concerns. However, these concerns are not much publicly
discussed and hardly acknowledged by developed countries. As the World Bank puts it:
Access to financial services is what matters for development, not who provides it.
32
6.2.2.1 Too little recognition of the need for new prudential measures
During the current GATS negotiations, many developing countries are not well informed
what policy responses and prudential measures to take that avoid the risks of greater
liberalisation of financial services. The WTO Committee on Trade in Financial Services
discusses some of these issues, including experiences of the range of new financial
measures and bodies introduced by some developing countries (e.g. Turkey, Malaysia,
China). However, many developing countries have no capacity to participate in the
Committee or to engage all relevant financial authorities back home.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 183
There is no widely accepted conceptual framework to make econometric estimates of
financial services liberalisation, and statistical data are inadequate to predict future
impacts.
33
Sudden intensification of competition by foreign new comers may encourage previously
protected domestic financial institutions to take short-sighted risky responses
34
, such as
reckless lending. Also foreign financial firms might engage in risky strategies to gain new
shares of the market. For instance, Argentina allowed large foreign ownership of banks
that failed to lend to small and medium-sized enterprises. The lack of safeguards to lend
to domestic firms prevented the Argentina economy to pick up after its first growth wave
ended in the 1990s.
35
In order to compete and attract more clients, financial conglomerates constantly introduce
new and more complex, hybrid financial products. If countries liberalise under GATS
according to he Understanding on Commitments in Financial Services (see above), the
host countries have to give permission to "any new financial service" that foreign financial
service providers introduce.
36
New services might include banking through internet and e-mail, 'e-banking', which poses
problems of supervision on money laundering and fraudulent activities, consumer
protection and avoidance of systemic failure.
37
Other new services might be derivative products and mutual fund management,
instruments that involve a significant speculative component.
Regulators and supervisors in developing countries will be challenged to take the
necessary measures and avoid the problems that occurred in Western countries, which
are supposed to have the best regulatory and supervisory regimes. As explained above,
Western countries had to revise regulations after problems of too much speculative
investment by pension funds and insurance companies. They also had to impose fines for
scandals of misusing knowledge, the creation of a stock market bubble and charging too
high fees.
China's experience
38
with foreign financial firms shows that transaction techniques have
become more complicated. As a result, China’s financial institutions are experiencing
tremendous changes, which increases the risk of instability. China has gradually reformed
its regulatory framework to adapt to international practice, but admits the administrative
capacity of the regulatory authority still falls far behind that of many developed countries
and that continuous reform and improvement is needed. This adds to the difficulties and
the high costs of administering the financial system.
In the future, Basel II rules might transform financial services markets in developing
countries (see above chapter 5). For instance, Basel II rules might make it more difficult
for domestic banks to compete against international banks that enter their market under
GATS commitments. Authorities will have to adapt to the situation and take necessary
measures.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 184
6.2.2.2 Foreign financial services increase cross-border capital flows and instability
One way by which foreign banks tend to import financial instability is by lending in
foreign currencies. In China for instance, foreign banks have become important
channels for bringing in foreign capital, by loans in foreign exchange amongst others. This
has had a major effect on China’s monetary policy, and has strained the macro-regulatory
mechanisms of its financial system.
39
The payment and repayment of loans in foreign exchange increase the rate of inflow and
outflow of international capital. When this results in an imbalanced exchange between
local and foreign currencies, it puts the exchange rate and foreign exchange reserves
under pressure, particularly if those loans are short-term. Too much demand for foreign
exchange increases the balance of payments deficit and with it the risk of exchange rate
and financial instability.
Other products that foreign financial firms introduce with financial market opening are for
instance "capital market products" such as investment instruments (e.g. mutual funds,
advise for management of a shares' portfolio). These instruments often offer domestic
residents to diversify their investments in shares and bonds issued by companies abroad
in addition to domestic ones.
40
Such services result in more cross-border capital
movements and can move in and out swiftly, especially when no capital movement
restrictions are in place.
New risk mitigation services and derivatives can also involve allocating money abroad.
While such services diversify risks, they are also speculative and it is difficult to estimate
by how much capital movements will increase and change direction.
When cross border capital flows reach significant volumes and a high velocity, or lead to a
balance of payments deficit, they can increase financial instability in the host country.
Speculative financial products can also import financial crises from abroad.
In addition, cross-border e-banking and buying foreign products -or even securities-
through internet ("mode 1" under GATS), typically involve cross-border capital movements
and foreign currencies. The lack of transparency in e-banking makes countries uninformed
how it will facilitate large destabilising cross-border capital movements, especially in small
countries.
41
What is difficult to predict
42
is how branches or subsidiaries of foreign financial firms and
their headquarters will behave in times of financial crises in developing countries.
Would they panic and move out all at once at the first sign of crisis as they did in 1997? Or
will they be able to resist the crisis with capital flowing in from the headquarters? In the
current Argentinean crisis, foreign banks refuse to recapitalize their branches and
subsidiaries.
43
Will they help transfer national savings abroad as in Argentina? Or will they
provide capital from abroad to finance current account imbalances? Most East Asian
countries have not been able to borrow in their own currencies, which means that they are
continuously exposed to problems that triggered the crisis in 1997. Smaller economies
such as in Sub-Saharan Africa are more vulnerable to capital movements which result in
financial volatility and destabilization of domestic bank credit.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 185
6.2.2.3 GATS articles promote cross-border capital flows and capital account
liberalisation
Some articles of the GATS agreement play a role in increasing the risks of destabilising
financial flows related to foreign financial service providers.
GATS Art. XI.1.
44
does not allow countries to restrict international transfers and payments
for current financial transactions that are related to services in sectors that were liberalised
under the Agreement. That means, first of all, that a country cannot prevent profit
repatriation by foreign service providers in sectors in which a country has made GATS
commitments. For instance, the EU requests from Chile in the current financial services
negotiations that Chile eliminates the "restriction" that prior authorization by the Central
Bank is required before transferring dividends from Chile abroad because this is in breach
of Article XI. Thus, if a country has liberalised the financial sectors, foreign banks and
insurance companies can transfer their profits abroad without reinvesting them in the
country. In countries that have small economies and/or large foreign investors in all
sectors, profit transfers affect negatively the balance of payments and exchange rate.
Moreover, Art. XI.1. has a special effect in relation to financial services provided by foreign
banks, insurers, investment bankers and asset managers which have established
themselves in countries that made GATS commitments in these services (Mode 3). These
financial service providers might view cross-border financial flows as "related to" or
essential to their services in cases such as:
lending in foreign currency;
buying securities abroad to balance the risks in pension fund management or to
increase the rate of return of asset management services (e.g. mutual funds) for
local clients or insurance companies;
providing investment bank services related to foreign stock exchanges
(underwriting shares of domestic firms listed abroad) or related to foreign
companies (acquisitions abroad);
offering international derivatives; and
using international credit risk mitigation mechanisms.
Such cross-border capital flows can go beyond current account transfers and undermine
management of the capital account aimed at avoiding financial instability and crises (see
box). If certain capital account restrictions frustrate the transactions of committed services
sectors, they could be challenged under GATS XI (see also below). In countries that have
already liberalised their capital account, GATS commitments in certain financial sub-sector
will increase instable capital flows. They might also discourage reversing capital account
liberalisation where considered necessary to avoid financial crises. Developing countries
that keep a high level of capital control are not likely to attract foreign financial firms as the
latter avoid unpredictable local currency convertibility and capital withdrawals.
45
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 186
Market opening in financial services and its impact on international
capital movements and financial stability
Article XI of the GATS is intended to guarantee the primacy of IMF rules in the area of
international capital movements. Obligations as to the liberalisation of cross-border
transactions in the WTO are linked to the commitments to market access included in a
country’s schedule and are designed to prevent their frustration in practice through restrictions
on the capital transactions necessary for their fulfilment. However, the decoupling in the GATS
of market opening for financial services from liberalisation of capital-account transactions
generally none the less leaves substantial scope for connections in practice. This is most easily
seen for the hypothetical example of a country which enters into commitments to no limitations
regarding Modes 1, 2 and 3 for all the activities mentioned in the Annex on Financial Services.
To ensure effective implementation of such commitments the country would be obliged to
undertake comprehensive liberalisation of capital-account transactions. Moreover a country -
not the one just described in the hypothetical example - whose commitments were made
through the Understanding on Commitments in Financial Services would also be making an
open-ended commitment to the liberalisation of such transactions required by its obligation to
“permit financial service suppliers of any other Member established in its territory to offer in its
territory any new financial service”. Although commitments as to market opening for financial
services often carry associated obligations as to the liberalisation of capital transaction, the
country making them will have to depend on guesswork for the estimation of the size of the
capital movements which are likely to ensue.
46
The difficulty of reaching estimates here is
increased by the pace of change in the financial sector, which is adding to the range of possible
transactions under the different modes of delivery of the GATS.
Source: A. Cornford, The multilateral negotiations on financial services: current
issues and future directions, 2003.
GATS Article XVI (“Market Access”) includes footnote 8 that commits a country to allow
a number of cross-border flows when it has opened up its market for particular (financial)
services: the country must allow inflows and outflows of capital that are considered
"essential" for (financial) services in mode 1 (e.g. e-banking) and allow inflows "related" to
mode 3 (i.e. foreign services provided by firms established in the country). Thus, countries
can only regulate the outflow of capital except for mode 1, if they have not already
deregulated capital flows by liberalizing the capital account as many developing countries
have done.
So far, the interpretation and impacts of Art. XI.1. and footnote 8 of Art. XVI in relation to
financial services are a little discussed area about which experts do not always have a
clear answer. This is reflected in discussions that have taken place
47
in the WTO about
opening up financial services that do not have a presence in the country but rather provide
their services from abroad (mode 1). Financial “products” such as lending of all types and
asset management provided by financial firms abroad can have a destabilizing effect
because they involve cross-border financial flows in foreign currency. In the view of Brazil,
the above mentioned footnote 8 of the GATS agreement could be tantamount to capital
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 187
account liberalisation and deregulation of major transfers of money, even if a country has
not fully liberalised its capital account system. Such cross-border capital transfers could
affect the balance of payments and the whole financial stability of a country. The
European Union, the US and other western countries downplay the importance of the
impact of opening up Mode 1 in financial services, but too little research has been done to
date on this issue.
6.2.2.4 GATS articles undermine measures to deal with destabilizing capital flows
Financial authorities need to have the capacity to carefully monitor changes in cross
border capital flows that result from financial services liberalisation. They may want to take
measures to prevent too much financial instability, especially in small countries where
swift flows can have a major impact. But GATS rules do not only influence what cross-
border capital flows are permitted, they also influence how restrictions on those flows are
managed.
Formally, GATS does not prevent any country from taking prudential measures to protect
depositors, investors or to ensure the integrity and stability of the financial system.
Art. XI.2. states that "nothing in the GATS agreement shall affect the rights and
obligations of the members of the international Monetary Fund under the Articles of
Agreement of the Fund". This legitimates controls over capital transactions since the IMF's
articles continue to permit policy autonomy regarding such controls.
48
These rights and
obligations, however, are subject to the condition that "a member shall not impose
restrictions on any capital transactions inconsistently with its specific commitments
regarding such transactions". In other words, IMF rights cannot undermine GATS
commitments.
WTO members are allowed to not apply Art. XI.1-2. In case of serious balance of
payment problems, Art. XII allows countries to restrict their market opening in (financial)
services sectors (financial or other services sectors) for which they made liberalisation
commitments, and to restrict cross-border money transactions related to committed
sectors. However, a country that invokes these restrictions is bound to fulfil a number of
conditions, including:
use criteria of non-discrimination and least-harmful effects on foreign service
providers;
be consistent with the Articles of the IMF;
limit the period the measures are in place;
undertake consultations with WTO members.
Ultimately, the assessment of the IMF of the financial situation of the country determines
whether the restriction measures are to be allowed (Art. XII.5.(e)).
6.2.2.5 GATS articles undermine prudential measures and regulations
Art. 2 of the GATS Annex on Financial Services (see above) permits domestic
regulations and prudential measures that protect a country against financial instability and
foreign exchange exposure. This article does not define prudential measures but
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Chapter 6 – Trade in financial services 188
stipulates that such measures are authorised to contravene other GATS provisions
("prudential carve-out"). However, the article states that prudential measures should not
be used to avoid market openings or obligations under the GATS agreement. These
conditions attached to the prudential carve-out measures may prevent countries from
taking measures, which, while contravening GATS commitments, are nevertheless the
most effective for dealing with financial instability.
The vagueness of what a prudential regulation may entail allows a WTO member to
challenge a measure of another WTO member as being not a prudential measure, but
rather a way to avoid GATS commitments or obligations. For instance, Western countries
robustly challenge prudential measures by China during current negotiations and WTO
reviews with the argument that they undermine financial services commitments.
49
In case
of disputes brought before the WTO, a panel must in such case decide what prudential
measure is permitted or trade restrictive to the foreign financial industry. Although the
GATS Annex on Financial Services (Art. 4.) specifies that a panel must have the financial
expertise necessary for the dispute, still, central banks and other regulators lose their full
freedom to impose the prudential regulations they see as essential.
6.2.2.6 GATS articles affect the management of the financial industry and
instability risks
GATS rules are oriented to protect foreign, in practice Northern, financial firms against
governmental measures that limit their expansion and profit making. As a result, some
GATS articles affect measures that especially developing countries have taken to avoid
abuses and risks taken by national or foreign financial firms, or to strengthen the domestic
financial industry before opening up to foreign competition.
Art. XVI on market access specifies six categories of measures which governments are
not allowed to carry out for those (financial) services on which they have made GATS
commitments. Governments sometimes use the prohibited measures in the financial
sector (which is central to its economy) for economic, sovereignty or prudential reasons.
Art. XVI prohibits:
limitations on the number of service suppliers (Art. XVI.a.) or service operations
(Art. XVI. c.)
limitations on the value of service transactions or assets (Art. XVI.b.),
measures that require specific types of legal entity or joint ventures (Art. XVI.e.),
and
limitations on foreign ownership capital (Art. XVI.f.).
Governments can only carry out such limitations for committed financial sectors if they
specify them as exemptions in the GATS "schedules" of their country.
Art. XVII on national treatment requires that foreign financial firms be treated not less
favourably than national firms. One of the implications of this GATS principle is that official
support for national financial firms in order to avoid financial instability, or to restructure
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 189
after a financial crisis, also needs to be given to foreign financial firms. There could be a
‘chilling effect’ if national support is not given because of potential conflicts with Art. XVII.
Licensing, qualification requirements and technical standards are part of ensuring the
integrity of the financial sector in some countries. They are being disciplined by Art. VI.4-5
on domestic regulation to ensure that they are not more burdensome than necessary
nor trade restrictive. As the latter principles still need to be developed, current
requirements and standards in financial services can be attacked as trade restrictive. This
is already the case with the EC’s requests for market opening for financial services to
different developing countries (see below). Eight small island countries
50
in the WTO have
heavily complained that footnote 3 of Art. VI.5. refers to international standard setting
bodies while small and developing countries have no say in many of these bodies which
impose costly regulation.
Interestingly, during the previous GATS negotiations, some countries have tried to
safeguard their freedom to take the regulations they see as necessary. They made explicit
references in their GATS ‘schedules’ to their prudential policy in order to be protected
against any GATS provision or commitment.
6.2.3 Who will decide on what prudential regulation and
capital account policies?
The contradictions between promoting trade and the interests of the financial service
industry on the one hand, and strengthening the national and international systems,
highlights many important issues that require an urgent answer.
6.2.3.1 The EU’s attack on financial regulations of developing countries
The current GATS negotiations to further open markets for financial services are mostly
done bilaterally between WTO members and based on ‘request lists’ and ‘offers’ (see
above). These negotiations are in principle secret but the requests of the EU were
leaked.
51
These texts demonstrate that the EU aims at eliminating many governmental
regulations which it considers trade restrictive for its financial industry. Developing
countries consider these regulations to be prudential or necessary for the country's
economy or financial industry.
Discouraging the strengthening of the domestic financial sector
Malaysia
52
has explained to the WTO that it has a 10-year programme to strengthen its
financial services sector after the financial crisis. The programme includes gradual
liberalisation without undermining financial stability, and measures that limit access by
foreign financial firms to the Ringgit. In its requests, the EU asks Malaysia
53
to remove the
latter measures such as "the prevention applied to foreign banks from having access to
local currency capital market".
Critical Issues in the Financial Industry
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Undermining domestic capital reserves
The EU requests to several countries to take away measures that compel banks to keep
reserves in the host country and not by the international parent bank at international level
(e.g. "allow branches to use parent's capital to meet prudential requirements", and "take
fully into account the guarantee extended by the branch's head office or by another
foreign bank for additional lending"). Such requests underestimate the need to allocate
reserves in the host country. Especially in times of world wide financial crisis, the parent
bank might not fulfil its guarantee for additional lending (as was the case in Argentina in
1994-1995
54
), might not have enough reserves for all its branches and subsidiaries world
wide, or might have its requested liquidity in foreign currency (adding to the complexity of
the crisis). It is easier and cheaper for financial conglomerates to keep capital reserves
central rather than divided in the countries of the different branches.
Encouraging tax evasion and off shore centres?
The EU made a request to Thailand to take away its limitation that foreign banks with an
offshore license cannot get access to the Thai market through full branch license. Most
foreign financial conglomerates are operating in 'offshore centres' such as the Cayman
Islands or Switzerland, which allow evasion of taxes and low cost transactions. As the
amount of money passing through offshore centres is huge, transactions with these
centres can be unreliable and volatile, and cause or transmit financial instability. How
does this EU request match the EU's own policy to confront offshore centres?
Interestingly, the US, Canada and Japan warned their financial firms to be wary of doing
business with he Caribbean offshore centres. The concerned Caribbean countries have
threatened to use the WTO dispute mechanism because when they considered these
warnings as restrictions on trade in financial services with those centres.
55
Limiting the scope to regulate in favour of poverty alleviation
In its request, the EU raises questions about the requirement applied to all banks in
Malaysia to provide quotas for low-cost housing and considers that it is a limitation that
should be scheduled. This means that measures to provide poorer families with the
financial resources needed for housing are not considered falling under the GATS "right to
regulate”, but rather as a trade barrier (read profit making restriction) that must be
exempted from the GATS agreement (Art. XVI), and ultimately eliminated.
Critical issues
Regulations that oblige banks to finance or invest in poor communities are not
popular with financial conglomerates. The EU request indicates that the secret
bilateral GATS negotiations might be a way to put pressure on such regulations
and ultimately to eliminate them. GATS rules might also undermine schemes that
reserve rural banking services to domestic banks, such as in the Philippines.
56
The right to regulate in the GATS preamble seems to be open to interpretation,
even for poverty related measures. This might be in contradiction with policies to
achieve the UN Millennium Goals.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 191
Exporting the problems of European pension fund managers?
The EU requests many countries to liberalise their pension fund management services.
The European pension fund managers have however proven to be not very proficient by
over-investing in the stock market and reduce their financial reserves for pensioners to a
level that regulators had to intervene. At a time when many private pension funds are still
in financial problems and privatization of pension funds is contested in Europe (Italy,
France) it would be politically inadvisable for the EU to promote private pension fund
management in developing countries.
Critical issues
Experience in Latin American countries shows that the benefits of pension reform
and privatization have been overestimated, and that the administrative costs are
high.
57
From a poverty perspective, the question is whether European pension
fund managers will be cheaper, make additional pension insurance available to
more poor workers or focus on the richest clients (cherry picking)?
The danger of secrecy and power plays in the GATS negotiations
So far is unclear how the different interpretations of necessary and prudential financial
regulations will play out during the negotiations. The EU has claimed that regulatory and
supervisory issues will be discussed during the bilateral negotiations but argues that its
requests are targeting trade restrictions. How will the EU handle the IMF’s assessment
that the regulatory system in Thailand is not yet efficient enough and that further
liberalisation entails systemic risks for that country?
During the secret bilateral negotiations, when the pressure to liberalise is the highest, it
will be a matter of the having most (economic) power to push for, or resist, the removal of
particular prudential measures. Prudential measures might be overlooked when trade
deals are made at the end of the Doha Round negotiations in order to achieve market
access in GATS that balances off other concessions (e.g. in agriculture by the EU and the
US). Harsh pressure to open up financial services takes also place during negotiations for
new membership of the WTO, as was the case with China.
6.2.3.2 Should the WTO handle disputes on prudential regulation?
Beyond those bilateral GATS negotiations on commitments, the question is what role the
WTO will or should play in prudential regulation. The negotiators have already discussed
the ‘prudential carve-out’ (see above) of the GATS Annex on Financial Services. Some
industrialised countries have proposed clearer definitions or closer links with international
standard setting bodies
58
or with supervisory activities of the IMF
59
. This could entail that
these standards or activities would be considered un-challengeable under GATS and
others not. In contrast, developing countries are more interested in keeping a broad
prudential carve-out that does not constrain their policy making.
One scholar (A. Kern
60
) puts the issue as follows: “[There is a] need to define prudential
regulatory standards in a manner that promotes a synthesis between trade and regulatory
values. The issue becomes whether the WTO should play a role in this process, and if not
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 192
which international bodies or organisations should be deferred to in setting international
standards of prudential regulation. The absence of a definition in this area means that
finding such a synthesis will be left to the adjudication proceedings of the GATS, and
potentially within the legislative jurisdiction of the WTO. The evaluation will also cover the
issue of the adequacy of the current international prudential mechanisms as benchmarks
for assessing a member’s prudential regulatory measures. This does not prepare for a
promising integration of the financial systems. It only stands to disturb the constitutional
balance of the international economic system by rendering GATS the de facto ultimate
arbiter of international financial regulation.” …“[T]he ambiguities surrounding the
interpretation of the concept of prudential regulation and its scope of coverage in the
‘prudential carve-out’ of the Financial Services Annex will likely result in many trade
disputes regarding the validity of prudential measures taken by members to ensure the
protection of investors, policyholders, shareholders, and to promote integrity and stability
of the financial system." …"[T]he WTO’s dispute settlement mechanism is an inefficient
mechanism to determine the right balance between free and open trade and prudential
safeguards.”
One of the issues that have not been clarified is whether measures to restructure
domestic banks after the Asian financial crisis, including injecting state money, are
distorting competition and discriminating against foreign financial service suppliers.
Already, the South Korean bank reform has been challenged in the WTO as a breach of
the WTO Agreement on Subsidies and Countervailing Measures, not under GATS! It
raises questions about the coherence between the WTO and the work of the IMF.
61
Critical issue
Danger of 'chilling effect' on Tobin Tax and other anti-speculative measures
The lack of clarity of what is allowed under the prudential carve-out of the GATS
raises the danger of a chilling effect on new measures that prevent a financial
crisis and its devastating effects on (poor) societies. For instance, in case a WTO
member made financial services commitments and introduced a currency tax
(e.g. “Tobin tax”) to stop volatile cross-border capital flows, the tax could be
accused by another WTO member of not being a prudential measure (as
opponents of the Tobin tax argue) or restricting international transactions related
to committed financial sectors (i.e. breaching of GATS Art. XI). Other WTO
members might refrain from introducing such tax fearing challenges under GATS.
6.2.4 Little link between the GATS negotiations and national
financial authorities
Notwithstanding the above described risks of financial instability and ambiguities about
prudential measures, the GATS negotiations make hardly any connection between the
functioning of the financial regulatory and supervisory system of a country on the one
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 193
hand, and the "requests" and "offers" on financial services on the other. No international
body is stopping requests for market opening in financial sectors, which are too risky in a
particular country.
The GATS negotiations on financial services liberalisation have often not involved officials
from the ministries and supervisory agencies working on reforms at the national level or at
international level (“the international financial architecture”). Especially in the EU and other
Western countries, the negotiations have been largely conducted by the ministries
responsible for trade or officials interested in supporting the domestic (or EU) financial
industry. This raises the question in how far countries liberalise financial services under
GATS to complement other financial reforms aiming at a more efficient and diversified
financial sector? “Trade [in the financial sector] should not be liberalised for trade’s
sake.”
62
The IMF and other international institutions have recognized that considerable and costly
capacity building is often required to educate regulators, supervisors, legislators and the
judiciary in order to create the appropriate framework for financial services. This means
that opening up financial services can only be successfully implemented when
accompanied by an orderly and well-designed policy and enough human and financial
resources. The IMF has a programme63 in place to monitor the reforms and the strength
of financial-sector regulation and supervision in many developing and emerging market
countries. But as the US representative put it during a WTO meeting of the WTO’s
Working Group on Financial Services, it is up to the negotiators of each country
concerned to deal with the issue themselves.
64
The EU requests also show little
coordination with the assessments of the IMF's programme. Developing countries wishing
to liberalise financial services could be fully using GATS exemptions and flexibilities, but
capacity to do so is often lacking.
GATS liberalisation provisions neglect wisdom gained after financial crises
Financial services liberalisation in line with all GATS rules and the 'Understanding'
disregards the global recognition after the Asian financial crisis that the stability of national
and international financial systems relies on the scale and sequencing of domestic
financial reforms. A gradual and considered approach to the deregulation of financial
services and financial flows is needed to make financial liberalisation beneficial for the
economy.
65
While the World Bank, IMF and Western countries argue that financial
services liberalisation increases financial stability and strengthens prudential soundness of
developing countries, they recognize that a well-sequenced capital account liberalisation
and domestic reform of the financial sector needs to be in place as well as appropriate
regulatory and adequate supervision. The financial crisis of 1997-98 has even convinced
the IMF that swift capital account liberalisation can lead to a financial crisis and that
sequencing of such liberalisation is necessary.
The setting up or acquisition of more establishments by foreign banks undermines
supervision by the host country while the lessons of the financial crises emphasise the
need for more transparency. Foreign banks might shift key decision-making and risk
management of their foreign establishments to the parent banks as is the case in
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Chapter 6 – Trade in financial services 194
emerging market countries.
66
This reduces information available to host country
supervisors. Moreover, the Basel Committee (see chapter 5) agreed that the authorities of
the home country of the bank supervise foreign establishments of banks, especially
branches. Foreign supervisors might have ample experience in monitoring foreign
branches but are mainly interested in avoiding bankruptcy of the bank
67
and less
concerned about the needs of the country in which their banks operate. Although
cooperation between home and host country supervisory authorities does exist
68
,
experience has learned that regulators and supervisors of countries in which foreign
banks operate might not have all the information they need. Central bank officials have
recently called for better cooperation between supervisors in order to avoid risks by
liberalisation of financial services in emerging market economies.
69
6.2.5 Too little coordination between GATS negotiations and
international stability fora
There is a worrying deficit in concern about the GATS agreement in institutions which
have competence regarding international finance regulation and supervision. Only a few
(informal
70
) contacts and discussions have taken place between the GATS negotiators
and international institutions such as the IMF, the Basel Committee on Banking
Supervision, and the International Association of Insurance Supervisors. An EU official
claimed he had difficulties to draw the attention of international supervisors' bodies to the
GATS negotiations
The current GATS negotiations take place at a time when the reform of the international
financial system announced after the Asian financial crisis has bogged down while far
from finished. This underscores the importance of prudential measures and capital
account management at the national level. The problem is that national measures and
supervision might not be enough to deal with the effects of financial services liberalisation.
Financial conglomerates connect many financial markets worldwide.
In East Asia
71
, the increasing domination of Western financial firms in capital market
services, that connect East Asia with the global capital markets, would not be a problem if
there were enough prudential regulations at the global level. There is no effective system
of liquidity provision that should enhance the stability and efficiency of the global financial
system in which East Asian countries are embedded.
For developing countries, there is no effective mechanism of globally monitoring all
services and transactions by particular financial conglomerates that are operating in their
markets.
72
International mechanisms to deal with potentially destabilizing effects of
increased international capital movements by foreign firms are still weak and not involving
all countries.
No efforts to achieve more transparency in the financial services industry
Ironically, the GATS agreement makes greater transparency of government regulations
and decisions a priority (e.g. Art. III, VI.3., VII.4., VIII.3.- 4., X.2) but it does not address
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 195
the lack of transparency of financial conglomerates, which poses many problems to host
country financial authorities.
Improved transparency by operating internationally banks is a key issue in the reform of
the financial system. Lack of information about too much short-term foreign currency loans
is seen as an important cause of the financial crisis. Publishing more information should
increase “market discipline” in the financial markets because it allows investors and
customers to better assess the bank’s state of affairs and, presumably, to act accordingly.
In addition it opens up more opportunities to supervisory authorities to play their role. A
review of fifty-four international banks in 2001 showed that the required disclosure is still
unsatisfactory.
73
There is however nothing in the GATS agreement that requires
governments to impose more transparency from the (foreign) financial firms whose
ownership structures, services and transactions remain often hard to scrutinize for
developing countries.
Need for more input from developing countries
There are thus overlaps between the work of the WTO and work in other international
institutions regarding international financial stability and the reform of its architecture. It is
high time that the linkages and contradictions between the international and national
efforts for financial stability and the GATS rules are fully discussed in many fora, based
not on theory but on concrete experiences and situations in developing countries. Better
participation of developing countries in international supervisory and standard setting
bodies would enrich the discussion and, hopefully, cater for their needs. The aim should
be to avoid any unforeseen consequences with detrimental economic, social and
environmental effects, as was the case during the Asian crisis. Better insights in the risks
for financial instability might allow all developing country governments to take the
necessary accompanying actions within the GATS negotiations and outside, or to wait for
further market opening until they have defined their financial needs and established the
necessary mechanisms.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 196
6.3 Summary with conclusions and critical issues
1. Prioritizing swift liberalisation
Opening markets for foreign financial services and investment by foreign financial firms
has been a priority in past and current GATS negotiations. The limited provisions under
the GATS agreement to deal with the special nature and systemic risk of financial services
are subordinate to commitments to liberalise. The special appendix, the 'Understanding
on Commitments in Financial Services', in the GATS agreement even provides a model
for the swift and full liberalisation of financial services ensuring no trade barriers or
obstacles to profit making by foreign financial firms are left.
2. GATS fits neatly with the interests of the Western financial industry
The top financial industry lobby in the West has been very active during GATS
negotiations. The GATS agreement and current GATS negotiations fit neatly with the
expansion ("consolidation") and profit-making strategies of the top financial
conglomerates. In contrast, the GATS agreement has no provisions to strengthen
universal access to financial services nor to tackle ‘cherry picking’, improve the quality of
financial services to all customers, and increase financing opportunities for poorer
individuals and entrepreneurs. The GATS agreement does not link up with
intergovernmental declarations that promote sustainable development or poverty
eradication or with corporate social responsibility initiatives.
3. Increasing competition and concentration
Increased competition following further GATS liberalisation is likely to reinforce and orient
the financial industry toward high profit making, concentration and consolidation. The
GATS agreement only has weak instruments (art. IX) with which to tackle market abuse
and restrictive business practices that will follow concentration and consolidation.
There is no discussion within GATS on how far financial services concentration can go
and on when financial conglomerates should not become ‘too big to fail’.
The GATS agreement focuses on more transparency from governments but fails to
improve the transparency of the complex financial industry. GATS should compel all
signatories of GATS to legislate the transparency of financial firms operating in their
country. This would somewhat enhance fair competition.
4. GATS reinforces the gaps between rich and poor
The liberalisation of financial services is claimed to improve efficiency in the financial
industry and the economy. The experiences of liberalisation in developing countries show
that there is much more at stake than increased efficiency, choice of products and access
to capital.
Foreign financial firms widen the gap between rich and poor by targeting
the richest clients, the most developed regions and the best personnel
from their host countries.
This undermines the competitiveness and efficiency of developing
country banks that have more expertise to cater for the needs of the
poorer clients or to invest in the domestic industry.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 197
As soon as developing country governments open their markets, foreign
firms often rapidly take over a large part of the domestic financial
industry.
Due to rapid foreign expansion, host countries must spend additional
resources for regulatory and supervisory measures to handle changes
and risks.
Profits made off rich clients in poor countries are siphoned off to the
home countries in the North. GATS prevents government restrictions on
profit repatriation.
Foreign firms provide rich clients in poor countries with more
opportunities to channel their money to the North and invest in Western
companies.
Host country governments have less leeway in directing the development
of their domestic market, and have much less influence in integrating
sustainable development practices.
The EU has even been using the GATS negotiations to question
developing country measures that support poverty alleviation.
5. GATS increases the risks of financial crisis
The liberalisation of financial services as such poses many threats to the financial stability
of the host developing countries and the international system. GATS reinforces those
threats, and both limits and challenges governments anz central banks to develop
independent policy. While GATS is not supposed to liberalise capital flows, GATS
liberalisation of financial services in practice does.
What is worrying is that Western negotiators brush aside concerns raised by developing
countries while the risks of financial instability in developing countries are not fully
analysed or discussed. The negative consequences felt by the poor and the environment
due to liberalisation and GATS rules are so significant that reducing the risk of financial
crises is paramount.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 198
The risks to financial instability come from:
New financial services can have significant destabilizing effects on a
developing country’s financial system. Increasing cross-border capital
flows or risky financial strategies necessitate that the right regulatory and
supervisory systems be in place.
GATS articles promote cross-border capital movements and financial
instability by limiting government restrictions on profit repatriation and
capital flows related to committed (financial) services (see Articles XI.1.
en XVI (footnote 8)).
GATS rules permitting restrictions on unstable capital flows and
(financial) services are limited by many conditions. These conditions
prioritize the interests of foreign-service providers rather than the
capacity of a developing country to deal with problems in its financial
system.
The vagueness of financial prudential measures which GATS permits
leave many developing countries' regulations open to challenges by
WTO disputes, or bullying by the hardliners during the secret bilateral
GATS negotiations (the EU is doing this). The vagueness and questions
of GATS interpretation could result in countries refraining from
introducing national legislation for fear of future WTO disputes (i.e. the
Tobin Tax)
6. Limiting policy space
In countries where the domestic financial sector needs improvement or is not yet capable
of competing with foreign competitors, GATS articles XVI, XVII and VI limit the
government’s ability to make this a priority. Governments can set out exemptions to
GATS articles which would allow regulators and central banks to maintain their policy
space. However, the process to do so is complicated and difficult for some developing
countries to negotiate.
7. Trade negotiators prevail
Too little coordination between the trade negotiators and the institutions responsible for
the national and international financial system, is a problem in most countries. As a result,
especially western GATS negotiators ignore the experience of previous financial crisis.
Namely, the liberalisation of cross-border financial flows and financial services of
developing countries needs to be gradual and well sequenced; building capacity and
institutions to monitor the financial system is costly and takes time.
As well, lessons learned from the IMF Financial Sector Assessment Programme or other
financial scandals in the West (e.g. mismanagement of pension funds' capital) have not
informed the GATS negotiations. The latter continue without fully considering the
difficulties in regulating complex financial conglomerates.
8. Where are the International financial safeguards?
No adequate safety nets or international financial safeguards against the increasing
instability risks from GATS liberalisation exist. Some Northern countries have promoted
the use of international standards in the GATS. However, various southern countries feel
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 199
these standards do not address their needs as they were originally developed by northern
countries.
Better coordination between the GATS negotiations and the international financial stability
institutions is necessary but with the reforms of the global financial architecture far from
complete, it is most important to support capacity building and increased participation from
developing countries at all these fora.
9. Need to change direction
Ideally, the current GATS negotiations in financial services should be stopped.
A different negotiation model should at least include the international standard setting
bodies where developing counties have full representation, the UN and civil society
groups. The aim of the new model would be to ensure that the financial service sector
works for the poor and for small and medium business, and promotes sustainable
development and issues raised by corporate social responsibility initiatives.
Any form of liberalisation of financial services, which does not serve the needs of the poor
or does not promote sustainable development, is a dangerous strategy that increases
global inequalities as well as increasing global instability.
Requests for financial services liberalisation from the west on southern countries are
disproportionate and most countries economies’ are not ready to be fully liberalised.
There should be much more open public and political discussions to avert the risks
identified in this report and stop unfair requests by the West. No commitments should be
made during the bilateral GATS negotiations, unless there is a full guarantee by both
sides that the necessary safeguards are in place, nor should the West insist on any such
commitments in financial services.
If developing countries want to liberalise financial services under the GATS they should
not make further commitments unless they get major concessions during the WTO
negotiations in services and other areas so as to compensate for the risks of financial
instability, higher regulatory and supervisory costs and reduction in domestic financial
sectors.
1
See www.uscsi.org/groups/finLeader.htm
2
See for instance the EU requests on financial services to Chile, Thailand, Malaysia at
www.gatswatch.org; see also below in this chapter.
J
World Development Movement, Whose Development agenda?, April 2003.
4
ACLI, the largest trade association representing the US Life Insurers.
5
74% of the market in 1998-2001.
6
See: Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 160-204: even the Japanese banks had to retreat from their top
positions.
7
Frankfurter Rundschau, 31July 2003; see also above, chapter 2.
8
For an overview see for instance G. Bies, Financial liberalisation in Latin America, in Developing
countries and GATS, Ed. C. Jepma, E. Kamphuis, Universtiy of Groningen (EC 134), 2003, p. 57-65.
9
See: WTO, Communication from the People`s Republic of China - Assessment of Trade in Services,
document nr. 19, 21, 22. 26, 41, 43, 44 45, 47, 48, 49, 50; WTO, Report of the meeting held on 9
December 2002- 13 January 2003 (TN/S/M/5) 12 February 2003, document nr. 7.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 200
10
Only the issues of poverty eradication and lending have been added by the author of this report. The
issues raised by China have been illustrated by experiences found in the literature.
11
V. Murinde & M. Tefula, A foreign affair? How far does Africa need foreign banks? in Finance matters -
Finance liberalisation: too much too soon?, id21 Insights #40, March 2002 (at:
www.id21.org/insights/insighths40/insights-iss40-art02.html).
12
See for more examples: World Bank, Finance for growth: Policy choices in a volatile world, Policy
research report, May 2001: summary of the report, at
www.worldbank,org/research/interest/policyresrpt.htm
1J
H. Huizinga, S. Claessen & A Demirgüç-Kunt, How does foreign entry affect the domestic banking
market?, World Bank Working paper nr. 1918, June 1998: based on the experience of 80 countries
between 1988 and 1995; G. Bies, Financial liberalisation in Latin America, in Developing countries and
GATS, Ed. C. Jepma & E. Kamphuis, University of Groningen, 2003, p. 64: based on research in Latin
America.
14
M. Karatas & M. Broadbent, Foreign banks in emerging markets: a Turkish success story, in id21
Society & economy, 29 April 2003 (www.id21.org/society/s7amk1g1.html): Turkey is not considered to
be typical of emerging markets because foreign banks only control 2% of domestic banking operations
(in Poland they control 36%) and 40% is still in hands of large public banks. Twenty-one foreign banks
are operating in the country. The most successful foreign bank has first served multinational and
government clients and was able to survive the financial crisis in Turkey (high inflation, volatile market)
through adaptive and aggressive strategies and by segmenting the market amongst others to financing
of the many privatization projects, focusing on corporate banking and credit cards, limiting its physical
distribution network and careful selection of clients and sectors to which it provides services. In other
words, foreign banks have the ability carefully select the most profitable sectors and clients and are not
interested in full expansion all over the country, increasing the unequal development between the
different Turkish regions.
15
M. Vander Stichele, Liberalisation in Banking Services Does not Have the Stated Effects - Summary of
a case study of ABN Amro in Brazil, SOMO/Amsterdam, December 2001 (www.somo.nl).
16
Challenges for the South in the WTO Negotiations on Services - Summaries and Conclusions from
Three Case Studies: Health Care (Kenya), Electricity (Colombia), Tourism (India), edited by SOMO &
WEMOS, Amsterdam, January 2003 (see www.somo.nl).
17
See The Banker, Foreign banks must cherry-pick less to avoid Latin American wrath, January 3
rd
2005
18
J. Marchetti (WTO Economic Affairs Officer, Trade in Services Division), letter of 25th June 2003.
19
WTO, Committee on Trade in Financial Services, Report of the meeting held on 6 October 2003, nr.
29.
20
H. Huizinga, S. Claessen & A Demirgüç-Kunt, How does foreign entry affect the domestic banking
market?, World Bank Working paper nr. 1918, June 1998.
21
See: Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 166-167, 178-179
22
The percentages are based on the table 2 from A. Cornford, The WTO negotiations on financial
services : current issues and future directions, Paper for the Financial Markets Center, 2004, p. 10-
11: they exclude banking entities from Japan; only countries for which figures for 1996 en 2000/2001
were available in the tables have been used.
2J
Brunei, China (more than average increase: 171%), Hong Kong, Indonesia (more than average
increase: 414%), South Korea, Malaysia, Philippines, Singapore, Taiwan, Thailand, Vietnam; the
presence of Japanese banks are not included.
24
Argentina, Brazil, Chile, Colombia, Ecuador, Peru, Uruguay, Venezuela; (Mexico is excluded from
these figures but is known to host many foreign financial firms).
25
Albania, Bulgaria, Croatia, Czech Rep., Estonia, Hungary, Latvia, Poland, Romania, Slovakia ,
Slovenia.
26
A. Cornford, The multilateral negotiations on financial services : current issues and future
directions, 2003, p. 5, 11-12.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 201
27
Africa`s insurance industry needs assistance, in Addis Tribune, 7 June 2002.
28
V. Murinde & M. Tefula, A foreign affair? How far does Africa need foreign banks? in Finance matters -
Finance liberalisation: too much too soon?, id21 Insights #40, March 2002 (at:
www.Id21.org/InsIghts/InsIghths40/InsIghts·Iss40·art02.html).
29
G. Bies, Financial liberalisation in Latin America, in Developing countries and GATS, Ed. C. Jepma &
E. Kamphuis, University of Groningen, 2003, p. 64.
J0
H. Huizinga, S. Claessen & A Demirgüç-Kunt, How does foreign entry affect the domestic banking
market?, World Bank Working paper nr. 1918, June 1998.
J1
The capital account covers (among others) capital movements for investments while the current
account mainly covers (the payment of) imports and exports of goods and services.
J2
World Bank, Finance for growth: Policy choices in a volatile world, Policy research report, May 2001:
summary of the report, p. 4 at www.worldbank,org/research/interest/policyresrpt.htm
JJ
A. Cornford, The multilateral negotiations on financial services : current issues and future
directions, 2003, p. 20.
J4
Eichengreen, Toward a new international financial architecture: A practical post-Asia agenda,
Washington (Institute for International Economics), 1999, p. 48.
J5
J. Stiglitz, Lessons from Argentina's debacle, in Sand in the Wheels (ATTAC Weekly Newsletter), nr
113, 16 January 2002.
J6
Art. 7 and Art. 11.D.3. of the Understanding on Commitments in Financial Services. Ironically, in the
US, the Securities and Exchange Commission often scrutinises financial products before they are
introduced.
J7
The potential problems were discussed in different meetings of the Committee on Trade in Financial
Services held in 2003.
J8
WTO, Communication from the People`s Republic of China - Assessment of Trade in Services, 19
December 2002, document nr. 18- 49.
J9
WTO, Communication from the People`s Republic of China - Assessment of Trade in Services, 19
December 2002, document nr. 18-49.
40
Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 153
41
A. Cornford, The WTO negotiations on financial services : current issues and future directions,
Paper for the Financial Markets Center, 2004, p. 14.
42
Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 186
4J
L.R. Reynoso, Argentina: la justicia inhibida, la Argentina de pie, in Correos para la emancipacion, nr.
234, 12 February 2004.
44
Art. XI.1.: ” Except under the circumstances envisaged in Article XII,"(see further below) "a Member
shall not apply restrictions on international transfers and payments for current transactions relating to
its specific commitments."
45
Yun-Hwan Kim, Financial opening under the WTO Agreement in selected Asian countries: progress
and issues, Asian Development Bank, Economic and Research Department, Working Paper No.24,
September 2002.
46
On the basis of his personal assessment for the activities in the Annex on Financial Services an IMF
observer attributes “major importance “ to “capital flows for virtually all financial services delivered
through mode 3 (commercial presence), as such presence by its nature implies some form of cross-
border investment”. Indeed, the only activities under the heading of banking and financial services
(excluding insurance) to which he does not attribute such importance are financial leasing, provision
and transfer of financial information, and advisory, intermediation and other auxiliary services. See
A.Kireyev, Liberalization of trade in financial services and financial sector (analytical approach), IMF
Working Paper WP/02/138, August 2002, pp. 10-14.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 202
47
See WTO - Committee on Trade in Financial Services, Report of the meeting held on 2 December
2002; IDEM, Report of the meeting held on 26 February 2003.
48
A. Cornford, The WTO negotiations on financial services: current issues and future directions, Paper
for Financial Markets Center, [2004], p. 6.
49
WTO, Committee on Trade in Financial Services, Report of the meeting held on 1 December 2003, part
D.
50
WTO, Committee in Trade on Trade in Financial Services, Report of the meeting held on 6 October
2003, part D.
51
See www.gatswatch.org
52
WTO, Communication from Malaysia: Challenges in the financial services sector, 30 July 2003 (WTO
document TN/S/W/17 S/FIN/W/28) discussed at meetings of the WTO Committee on Trade in Financial
Services held on 7 July and 6 October 2003
5J
See www.gatswatch.org: EC requests to Malaysia, Financial services, p.3.
54
M. Metzger (BIF Berlin), letter of 11 December 2003.
55
Tax havens seek WTO intervention, in FT, 2 October 2 2000.
56
Friends of the Earth - US, Sustainability and accountability in the financial services sector, declaration
released in January 2003, p. 3.
57
M. Queisser, Pension reform: lessons from Latin America, OECD Development Centre Policy Brief, nr.
15,1998, see also H. Reisen, Liberalization foreign investment by pension funds: positive and
normative aspects, OECD Development Centre Technical Paper nr. 120, January 1997.
58
For instance: the Basel Committee on Banking Supervision, the International Association of Insurance
Supervisors (IAIS), International Organisation of Securities Commissions (IOSCO) and the Joint Forum
on Financial Conglomerates. The Financial Stabiltiy Forum has classified 12 international financial
standards as key standards for financial stability. Developing countries are not always well represented
in these international bodies whose standards might not always be fully adequate in developing
countries. For further explanation: see chapter 5.
59
The IMF Financial Sector Appraisal Programme (FSAP): the programme assesses the vulnerabilities of
a country's financial sector and actions to be undertaken.
60
Alexander Kern, The World Trade organisation and financial stability: the need to resolve the tension
between liberalisation and prudential regulation, ESRC Centre for Business Research Cambridge
University (Working Paper No.5), 2002, p. 5, 45.
61
A. Cornford, The WTO negotiatins on financial services : current issues and future directions, Paper
for the Financial Markets Center, 2004.
62
N. Tamirisa et.al., Trade policy in Financial Services, IMF Working Paper N0.31, 2000, p.12.
6J
The IMF`s Financial Sector Assessment Programmes (FSAPs) monitor domestic financial sectors in
developing countries and provide technical assistance to strengthen them. The IMF's has also been
monitoring and assisting the liberalization of capital accounts which has been seen as one of the
problems leading to the Asian financial crisis.
64
WTO, Committee on Trade in Financial Services, Report of the meeting held on 26 February 2003.
65
Finance matters - Finance liberalisation: too much too soon?, id21 Insights #40, March 2002 (at:
www.id21.org/insights/insighths40/insights-iss40-art00.html); see also: World Bank, Finance for growth:
Policy choices in a volatile world, Policy research report, May 2001.
66
BIS, Foreign direct investment in the financial sector of emerging market economies, Report submitted
by the Working Group established by the Committee of the Global Financial System, March 2004, 1-2.
67
Basel Committee on Banking Supervision, Principles for the Supervision of Banks’ Foreign
Establishment, May 1983, Art. IV: this is the basis of supervising establishments abroad, called the
‘Concordat’ and replaces the first version of 1975.
68
Basel Committee on Banking Supervision, Information flows between banking supervisory authorities,
April 1990: is an addition to the Concordat because there was not enough cooperation (possible)
between supervisors of home and host countries.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 203
69
BIS, Foreign direct investment in the financial sector of emerging market economies, Report submitted
by the Working Group established by the Committee of the Global Financial System, March 2004, 1-2.
70
See WTO, Committee on Trade in Financial Services, Report of the meeting held on 7 July 2003,
(S/FIN/M/41), nr. 2: an informal meeting took place between (the chair of ) the Committee on Trade in
Financial Services and the Basel Committee on Banking Supervision and the International Association
of Insurance Supervisors on 27 June 2003 but members of the Committee would be briefed about the
visit in “informal mode” by the chair (as agreed during the previous Committee meeting held on 16 May
2003).
71
Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 185: East Asian policy makers regret that there is:
- no reliable global or regional lender of last resort
- no agreement among the global community to establish a global regulatory authority
- not enough effort to expanding and strengthening cross-border financial supervision and regulation by
advanced countries with developed financial markets
- an absence of effective cross-border prudential supervision of foreign financial companies operating
out of East Asian financial markets.
72
Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 185-186; see also activities of the Joint Forum on Financial
Conglomerates.
7J
See chapter 5: only 63% of the items considered important by the Basel Committee of Banking
Supervision (the association of major supervisory authorities). While that was an improvement over the
previous years, it was still far from sufficient. In particular, information about their techniques for
mitigating credit risks (including more speculative credit derivatives) was lacking, which makes it
difficult to monitor from the outside their practices and expertise for avoiding bad loans, a major source
of (in)stability
The need for more transparency became clear during the financial crisis in South East Asia in 1997-98.
There was too little oversight that foreign banks had been giving too much short term foreign currency
loans.
Critical Issues in the Financial Industry
Annexes 204
Annexes
For the annexes and more information about the financial sector and financial
corporations see our website: www.somo.nl, look for <file> financial sector.
Annex I:
UNEP Statement by Financial Institutions on the Environment & Sustainable
Development
See http://www.unepfi.org/signatories/statements/fi/
Annex II:
The "Equator Principles"
See http://www.ifc.org/ifcext/equatorprinciples.nsf/Content/ThePrinciples
Annex III:
CEO’s and Chairmen statement of companies operating in the financial sector of
WBCSD
See http://www.wbcsd.ch/DocRoot/5PV72pFXVXcIqJX88UlC/20020925_finance.pdf
Annex IV:
The Collevecchio Declaration on Financial Institutions and Sustainability
See http://www.foe.org/camps/Intl/declaratIon.html
Annex V: NGO
Collective Analysis of the Equator Principles
See http://www.globalpolicy.org/socecon/ffd/2003/06ngos.htm
For a summary of the main points see http://www.ran.org/news/equator_ngo.html
Annex VI:
UNEP Statement of Environmental - Commitment by the Insurance Industry
See http://www.unepfi.org/signatories/statements/ii/
Annex VII:
Gri financial services sector supplement on social performance (November 2002)
See http://www.globalreporting.org/guidelines/sectors/GRIFinancialServices.pdf
doc_902445295.pdf
The private financial industry plays a pivotal role in the functioning of many economies in the world. Banks, insurance companies and other less well-known financial service providers intermediate capital flows for governments, corporations and individuals, which affect people’s lives and the choices available in society.
Critical Issues in the
Financial Industry
SOMO Financial Sector Report
Myriam Vander Stichele
SO M O
This SOMO report critically analyses the functioning and regulation of banks,
insurance companies and other ?rms in the ?nancial industry. Although the ?nancial
industry is a crucial player in corporate globalisation, e.g. through its “investment
banking”, civil society scantly monitors the private ?nancial sector. This report
aims at explaining the terms used in the private ?nancial sector and increasing the
understanding of its functioning.
More speci?cally, the report focuses on trends, structures, strategies, regulations and
corporate social responsibility initiatives at the international level. The analysis clearly
identi?es “critical issues” that reveal the negative effects of the ?nancial
industry on society, developing countries, poverty eradication, and sustainable
development. This report intends to support the work of civil society organisations
and individuals who are involved in campaigns dealing with issues such as destructive
projects ?nanced by banks, corporate social responsibility, GATS, stopping unstable
and speculative capital ?ows, poverty eradication and sustainable development.
Critical Issues in the Financial
Industry
SOMO Financial Sector Report
Myriam Vander Stichele
April 2005 (updated)
Colophon
Critical Issues in the Financial Industry
SOMO Financial Sector Report
By:
Myriam Vander Stichele
Update in 2005 assisted by Jante Parlevliet
Published by:
Stichting Onderzoek Multinationale Ondernemingen
(SOMO)
Centre for Research on Multinational Corporations
Cover Design:
Annelies Vlasblom
Copyright © 2005
First published in March 2004
SOMO, Amsterdam
This report is financed by:
The Dutch Ministry of Foreign Affairs and NOVIB
Additional copies are available from:
SOMO
Keizersgracht 132
1015 CW Amsterdam
Phone: +31 (0)20 6391291
e-mail: [email protected]
Download and ordering at www.somo.nl
Contents
Contents................................................................................................................... 3
General introduction What the report is about .................................................... 6
Glossary ................................................................................................................... 9
Some figures to compare ..................................................................................... 11
Chapter 1 Financial services: what they are, some trends and critical
issues ..................................................................................................................... 13
Introduction .....................................................................................................................13
1.1 Banking................................................................................................................13
1.1.1 Retail banking and commercial banking...............................................................13
1.1.2 Lending of all types and related services .............................................................16
1.2 Services related to securities and asset management .........................................23
1.2.1 Investment banking..............................................................................................23
1.2.2. Private equity firms...............................................................................................28
1.2.3 Research, trading and brokerage.........................................................................29
1.2.4 Derivatives services .............................................................................................31
1.2.5 Hedging................................................................................................................33
1.2.6 Asset management ..............................................................................................36
1.2.7 Pension funds ......................................................................................................36
1.2.8 Mutual funds ........................................................................................................37
1.2.9 Trust services.......................................................................................................40
1.3 Rating services ....................................................................................................41
1.4 Insurance services ...............................................................................................42
1.5 Conclusions from the perspective of poverty eradication and sustainable
development ........................................................................................................46
Chapter 2 Insights in the financial industry: trends and strategies................ 51
Introduction .....................................................................................................................51
2.1 Performance of the financial services industry.....................................................51
2.2 Structure of the financial industry: rankings of top financial firms.........................54
2.2.1 World rankings.....................................................................................................54
2.2.2 A short analysis of the world top financial conglomerates....................................55
2.2.3 Regional rankings ................................................................................................59
2.2.4 Sectoral ranking...................................................................................................61
2.2.5 Global concentration in some financial services sectors......................................63
2.3 Trends and strategies: financial service companies.............................................64
2.3.1 Consolidation .......................................................................................................64
2.3.2 Competition..........................................................................................................69
2.3.3 Shareholder value................................................................................................72
2.4 Conclusions and critical issues ............................................................................73
Chapter 3 The case of Indonesia ......................................................................... 77
Introduction .....................................................................................................................77
3.1 Domination of the banking sector compared to other financial services .............. 77
3.2 The role of banks in servicing the poor ................................................................ 77
3.2.1 Weak support for small and medium sized enterprises ....................................... 77
3.2.2 The role of banks and the poor............................................................................ 78
3.2.3 Foreign banks give little or no credit to poor ........................................................ 79
3.2.4 Neglecting poor regions....................................................................................... 79
3.2.5 Increase in consumer credit rather than investment credit .................................. 80
3.3 Deregulation and the lack of regulatory and supervisory capacity....................... 82
3.4 The critical roles of lending by foreign banks....................................................... 82
3.4.1 The role of lending by foreign banks in the financial crisis................................... 82
3.4.2 Odious governmental and private debt ................................................................ 83
3.5 Private project and company financing carried over to governments .................. 85
3.6 Privatization......................................................................................................... 87
3.6.1 Privatization of the banking sector....................................................................... 87
3.6.2 Financing privatization by the financial industry................................................... 88
3.7 Critical issues related to labour in the private financial sector ............................. 89
3.7.1 Lay offs................................................................................................................ 89
3.7.2 Not respecting labour laws .................................................................................. 89
3.7.3 Discrimination between foreign and domestic employees at foreign banks......... 89
3.8 Conclusions: critical issues for developing countries........................................... 90
Chapter 4 Corporate Social Responsibility initiatives in the financial services
sector ......................................................................................................................92
Introduction..................................................................................................................... 92
4.1 CSR initiatives and guidelines covering all financial services.............................. 93
4.1.1 UNEP Finance Initiative....................................................................................... 94
4.1.2 The EPI-Finance 2000 initiative to develop environmental measurement
indicators ............................................................................................................. 96
4.1.3 WBCSD Working Group Finance ........................................................................ 97
4.1.4 UN ‘The Global Compact’ Financial Institutions’ Initiative.................................... 98
4.1.5 Wolfsberg principles............................................................................................. 98
4.1.6 The Collevecchio Declaration by NGOs .............................................................. 99
4.1.7 Further developments and critical issues........................................................... 101
4.2 CSR aspects in retail and corporate banking..................................................... 102
4.2.1 Project financing................................................................................................ 102
4.2.2 Equator Principles by banks .............................................................................. 102
4.2.3 Beyond the Equator Principles .......................................................................... 104
4.2.4 Integration of environmental and social aspects in regular corporate financing. 106
4.2.5 Retail banking.................................................................................................... 106
4.2.6 Alternatives ........................................................................................................ 107
4.3 Asset management and socially responsible investment................................... 107
4.3.1 Investing in companies - socially responsible investment (SRI) ........................ 108
4.3.2 Mutual funds and ethical funds: is there a difference?....................................... 109
4.3.3 UN norms for responsible investments for institutional investors....................... 110
4.3.4 Pension fund management ................................................................................ 110
4.4 Insurance and Corporate Social Responsibility ................................................. 111
4.4.1 Responsibility on social aspects not yet developed........................................... 111
4.4.2 Environmental issues in CSR initiatives............................................................. 113
4.4.3 UNEP Finance Initiative on insurance focuses on environment.........................114
4.4.4 Example of individual or branch CSR Initiatives................................................114
4.5 Investment banking............................................................................................115
4.5.1 CSR issues from the Global Reporting Initiative ................................................115
4.5.2 Issuing bonds from the World Bank ...................................................................116
4.5.3 Emissions trading...............................................................................................116
4.6 Reporting initiatives by financial institutions.......................................................116
4.6.1 Social performance reporting through the GRI Financial Services Sector
Supplement........................................................................................................117
4.6.2 Environmental reporting indicators.....................................................................119
4.6.3 Reporting on sustainable credit activities by banks............................................120
4.7 Conclusions and critical issues ..........................................................................122
Chapter 5 Governmental regulations at the international level.................... 128
Introduction ...................................................................................................................128
5.1 Trends of regulation and supervision at national levels .....................................128
5.2 Regional financial services markets and regulation ...........................................131
5.3 International regulation and supervision of corporate financial services ............132
5.3.1 Bank for International Settlements (BIS) ............................................................134
5.3.2 International Association of Insurance Supervisors (IAIS) .................................141
5.3.3 International Organisation of Securities Commissions (IOSCO) ........................142
5.3.4 Supervising and regulating all-finanz firms.........................................................144
5.4 Regulation, supervision and decisions related to capital flows and the
international financial system.............................................................................146
5.4.1 International fora for discussing financial system stability..................................147
5.4.2 State of the reform of the international financial system.....................................152
5.5 Relation of financial services with auditors.........................................................156
5.6 Conclusions and critical issues ..........................................................................158
5.7 Sustainability and Accountability in the Financial Services Sector Regulatory
and public policy recommendations ...................................................................161
Chapter 6 Trade in financial services: liberalisation in the GATS Agreement
and insufficient assessment of the risks.......................................................... 168
6.1 The GATS instruments to liberalise financial services .......................................168
6.1.1 The rules of the GATS Agreement .....................................................................168
6.1.2 The Annex on Financial Services.......................................................................171
6.1.3 The GATS agreement includes a model for swift liberalisation..........................171
6.1.4 After the Uruguay Round: the Fifth Protocol to the GATS..................................173
6.2 Assessing the risks for developing countries .....................................................173
6.2.1 Liberalisation of financial services under GATS.................................................173
6.2.2 The risks of financial instability in developing countries .....................................182
6.2.3 Who will decide on what prudential regulation and capital account policies?.....189
6.2.4 Little link between the GATS negotiations and national financial authorities......192
6.2.5 Too little coordination between GATS negotiations and international stability
fora.....................................................................................................................194
6.3 Summary with conclusions and critical issues ...................................................196
Annexes................................................................................................................ 204
Critical Issues in the Financial Industry
General introduction – What the report is about 6
General introduction
What the report is about
The private financial industry plays a pivotal role in the functioning of many economies in
the world. Banks, insurance companies and other less well-known financial service
providers intermediate capital flows for governments, corporations and individuals, which
affect people’s lives and the choices available in society.
By raising, allocating and pricing capital and providing risk coverage, they have a major
influence on:
who in society gets access to financing and protection against risks;
what activities by governments, corporations or individuals get financed or
protected against risks;
how financial services benefit the rich or the marginalized, sustainable
development or environmental destruction.
The private financial sector has several types of financial services that affect societies as
well as the international economy. Regulating and supervising financial firms and their
diverse services is difficult due to the complexity of financial ‘products’ and risk
management, and due to the speed at which financial firms facilitate huge amounts of
capital to flow around the world. Moreover, the private financial industry has successfully
argued for national and international free markets and legal frameworks that prevent too
much intervention by national and international authorities.
After crises like the Asian financial crisis in 1997-98, there was a lot of talk about reform of
‘the’ financial architecture. It is often overlooked that the dominant players in international
financial system are private financial services providers, including the ‘institutional
investors’. Because there is much less public knowledge about financial firms than about
governmental financing institutions like the World Bank, this financial sector report focuses
on private financial firms including banks, insurance companies, investment banks and
pension funds. The report intends to provide basic information about:
the mechanisms and the operation of private financial services (chapter 1),
the structure and the major players in the financial services market, and trends
and strategies in the financial industry (chapter 2),
important issues and concerns for developing countries, based on a case study of
Indonesia (chapter 3),
initiatives taken around corporate social and environmental responsibility (chapter
4),
how the private financial industry is regulated and supervised at the international
level (chapter 5),
Critical Issues in the Financial Industry
General introduction – What the report is about 7
how trade in financial services and investment by financial firms is regulated by
the WTO agreement on services (GATS) and what the risks are for developing
countries (chapter 6).
This report focuses on trends, structures, regulations and corporate responsibility
initiatives at the international level. The scope of the report did not allow for analysis of
each country. Only an Indonesian case study by Business Watch Indonesia on the
financial services industry is included to provide a useful developing country insight.
Each chapter strives to indicate the problem areas in every financial sub-sector. The focus
is on those aspects that negatively affect society, developing countries, poverty
eradication, and sustainable development. These are indicated as "critical issues". The
conclusions of each chapter review the main critical issues and topics.
In this way, the report would like to inform and analyze problems surrounding the private
financial industry for organizations, individuals and institutions which:
are involved with corporations, big projects and privatization, and their financiers,
which destroy the environment and violate human rights;
are campaigning about trade agreements, such as the GATS agreement, in which
opening of the financial services market is on top of the agenda without any
democratic scrutiny;
want to free the world of unstable international capital flows and complex financial
services that undermine entire economies and people’s lives;
want to solve debt problems of developing countries, which reduce government
budgets intended for eradicating poverty, social improvements and promoting
environmentally friendly development;
want to avoid the widening gap between rich and poor in all countries and work
on alternatives to the current globalised free market economy;
understand what goes on behind corporate scandals such as Enron and
Parmalat.
The report is published by the Centre for Research on Multinational Corporations
(SOMO), a non-profit research institute that advises non-governmental organizations and
trade unions in the Netherlands and worldwide.
Research for this report was based on information from literature, data bases, NGO
analysis and input at workshops in Cancun (12 September 2003), The Hague (19
November 2003) and Amsterdam (13 January 2005), and last but not least the sector,
country and corporate reports commissioned to Business Watch Indonesia. The expertise
of SOMO researchers and writing by Myriam Vander Stichele lead to the analyses and
results of this report. Thanks go to Martin Koehler (Campagna per la reforma della Banca
Mondiale), Peter Wahl (WEED), Johan Frijns (Bank Track), and others who commented
and supported the writing of the report. In beginning 2005, the report was updated with the
assistance of Jante Parlevliet to incorporate most important new events.
Critical Issues in the Financial Industry
General introduction – What the report is about 8
SOMO's research of the financial sector is part of a four-year program of research of
sectors of importance to civil society, poverty eradication and sustainable development,
financed by the Ministry of Foreign affairs in the Netherlands. Financial support for
researching the financial sector also came from NOVIB (NL).
Myriam Vander Stichele
Amsterdam, April 2005
Critical Issues in the Financial Industry
Glossary 9
Glossary
This report explains many words used in the financial services industry, mostly in chapter
one. A word that is explained for the first time in the report is underlined. Below are some
general terms used throughout the report.
Assets
Anything that has commercial or exchange value and is owned by a business, institution
or individual, for instance shares or real estate.
Bailing out
Financial support by governments to banks or other financial firms that are in financial
distress and could go bankrupt, possibly disrupting the whole economy.
Bond
An interest-bearing security issued by governments, banks or companies, which obligates
the issuer to pay the bondholder a specified sum of money, usually at specific intervals,
and to repay the principal amount
Credit risk: the chance that the debtor will not repay the loan or other form of debt (e.g. a
bond).
Collateral: something of value that is given as a guarantee for repayment of a loan or
other form of debt. Often it concerns real estate but many other assets can be used,
including land, part of a business, or financial assets. In case the borrower fails to repay
the loan on the agreed terms, the bank will have the legal right to seize the collateral.
Debt finance: with this form of finance, the financiers lend money to a company,
government or project. This can be in the form of a bond or a loan. The returns of the loan
and bonds are normally fixed.
Deposit: a sum of money lodged at a bank or other depository institution. The money can
be withdrawn immediately or at a agreed time (‘time deposits’). Sometimes deposit earn
interests, especially if it concerns a time deposit.
Derivative
A contract which specifies the right or obligation between two parties to receive or deliver
future cash flows, securities or assets, based on a future event.
Equity finance: in this form of finance, financiers buy a share in the company or project
and are thus a partial owner. Their returns depend on the success of the firm/project.
Equities
Ordinary shares, i.e. ownership interests possessed by shareholders in a corporation, as
opposed to bonds.
FT
In references means: the Financial Times
FTFM
In references means: Financial Times Fund Management (weekly review of the
investment industry)
Critical Issues in the Financial Industry
Glossary 10
Institutional investors
Investors with large amounts of funds under their management, such as pension funds,
insurance companies, mutual funds and bank trust departments.
Principal
Amount of a loan, separate from interest to be paid.
Securities
Bonds, shares or stock, and derivatives.
Securitization
Process of bringing together in a pool debt instruments (e.g. loans) which generate
predictable cash flows, then selling to investors new securities backed by the pool.
Stock
Is the equivalent of the UK term share(s).
Share
Units of ownership in a company, issued by a company as a means of raising long term
capital; shareholders receive some part of the company's earnings through dividends;
"voting shares" carry the right to vote at company meetings.
Reserve requirements: requirements on the amount of funds a bank has to hold in reserve
against deposits made by their customers. This money has to be held in the vaults of the
bank, or the respective central bank.
Underwriting
Introducing new shares on the stock market and assuming the risk of buying the new
issue of shares or bonds from the issuing corporation or government entity and reselling
them to the public; the underwriter guarantees to buy any shares of a share issue which
are not bought by the public, which creates public confidence.
Syndicated loan: loans for large, possibly risky commercial or government projects
provided by a group of banks and other financial institutions, called a bank consortium or a
syndicate.
Option: a contract between two parties that offers the buyer of the option the right to buy
(or to sell) an asset (e.g. a financial security) from (to) the contracting party at a agreed
upon price, within a certain period of time.
Future: a contract between two parties in which the buyer of the future party is obliged to
buy (or to sell) an asset (e.g. a financial security) from (to) the contracting party, at a
agreed upon price, within a certain period of time.
Critical Issues in the Financial Industry
Some figures to compare 11
Some figures to compare
Gross Domestic Production (GDP) in 2003
1
Gross domestic product of the economically richest country, the US $ 10, 949 bn
($ 11,0 trillion)
GDP of the reported poorest country, Kiribati $ 0.055 bn
($ 55 million)
Total GDP reported in the world $ 36,460 bn
($ 36.5 trillion)
Gross National Income (GNI) per capita 2003
2
GNI per person in the richest country reported, Luxembourg $ 45,740
GNI per person in the poorest country reported, Ethiopia $ 90
World GNI per capita $ 5,510
FDI
Total world foreign direct investment (FDI) in 2002 $ 651 bn
Total FDI to developed countries in 2002 $ 460 bn
Total FDI to developing countries in 2002 $ 162 bn
AID
Total official overseas development aid (ODA) in 2002 $ 58 bn
Additional annual aid needed to achieve Millennium Development
Goals $ 40-60 bn
Debt
5
Total debt of all developing countries in 2003 $ 2,554 bn
($ 2.6 trillion)
Total debt by all developing countries to private creditors $ 595,1 bn
Developing countries’ use of IMF credit in 2003 $ 106,9 bn
Trade
6
Total world exports of merchandise in 2003 $ 7,579 bn
($ 7.6 trillion)
Total world exports of commercial services in 2003 $ 1,729 bn
($ 1.7 trillion)
Financial markets in 2003
7
Total value of equities (world stock market capitalization) in 2003 $ 31,202 bn
($ 31 trillion)
Total world value of public and private debt securities in 2003 $ 51,305 bn
($51 trillion)
Total value of assets managed by commercial banks (bank assets)
in 2003 $ 47,834 bn
($ 48 trillion)
Critical Issues in the Financial Industry
Some figures to compare 12
Value of US mutual fund industry in January 2004
8
$ 7,537 bn
($ 7,5 trillion)
Value of US hedge fund industry in January 2004
9
$ 795 bn
Notional value of global amounts outstanding of
over-the-counter (OTC) derivatives by June 2003
10
$ 169,678 bn
($169.7trillion)
Total recorded claims on offshore centres in the second quarter
of 2003
11
$ 1,800 bn
($ 1.8 trillion)
Profits of financial firms
Total net profit
12
of the 41 financial firms that belonged to the 100
biggest global companies in 2002-2003 $ 166.9 bn
Total net profit of Citigroup, the world's top financial firm, in 2004
13
$ 17.0 bn
Commissions paid by migrant workers for transferring earnings home,
according to US Treasury registration in 2001
14
more than $1bn.
Pensions
Total pension fund assets of the world's top 5 pension markets
in 2003
15
$13,077 bn
Pension funds are world wide under funded by 20% $1,500 bn to $2,000bn
1
World Bank, Quick Reference Tables, Total GDP 2003, at www.worldbank.org
2
GNI differs from Gross National Product (GNP) in that it includes a terms of trade adjustment. See:
World Bank, Quick Reference Tables, GNI per capita 2003, at www.worldbank.org
3
UNCTAD, Development and Globalization. Fact and Figures. 2004, p33, at www.unctad.org
4
OECD, OECD Report Shows Rising Aid Flows but More Effort Needed to Reach Monterrey Goals, 28
January 2004.
5
World Bank, World Development Indicators 2005, table 4.16, at www.worldbank.org. Developing
countries here refers to World Bank’s low and middle income countries
6
World Bank, World Development Indicators 2005, tables 4.5 and 4.7, at www.worldbank.org
7
IMF, Global financial stability report, April 2005, p. 163
8
Grace Toto, Monthly statistical review, SIA Research Reports, 20 September 2004, p 27, at
www.sia.com
9
Kyle L. Brandon, The State of Hedge funds: 2004, SIA Research Reports, 20 September 2004, p 6, at
www.sia.com
10
BIS, Quarterly review, March 2004, p. A99
11
BIS, The international banking market, in Quarterly review, December 2003, p. 16
12
Forbes 2000 list, March 2004, at: www.forbes.com : based on a composite of sales, profits, assets and
market value; including figures of net profits in 2003 and 2002.
13
Citigroup, Annual Report 2004, available at www.citigroup.com
14
J. Authers, Mexicans send more than $ 1 bn back home in July, in FT, 19 September 2003.
15
Watson Wyatt, in S. Targett, Pension gloom is lifting, in FTfm, 19 January 2004, p. 2
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 13
Chapter 1
Financial services: what they are,
some trends and critical issues
Introduction
The private financial industry, or “financial services sector”, makes money by raising and
allocating capital, and by providing protection against many kinds of risk.
The various financial services and the ways in which they work will be explained
1
in this
chapter. The latest trends, problems and some critical issues relating to sustainable
development and poverty eradication will also be outlined for each branch of financial
service.
Some financial services may seem obvious, whilst others are much more complex and
less transparent to the general public or civil society organizations.
Chapter 2 will give more insight into which firms provide the various financial services, and
the structure and the trends in the financial services market. Issues related to developing
countries, corporate responsibility, regulations and liberalisation of these financial services
are also explained in separate chapters.
The overview below is organized categorically with the services the financial industry
offers. These financial services categories are also used in the free trade agreements,
including the agreement on services in the GATS agreement of the WTO (see chapter 6).
1.1 Banking
1.1.1 Retail banking and commercial banking
Retail and commercial banking refers to banking services open to the households and
small companies. In contrast, corporate banking focuses on large, corporate and
institutional clients (‘wholesale clients’) only.
Commercial banking
There are different kinds of retail banks. The biggest group are the commercial banks,
which service both households and small and medium enterprises (SME’s) and wholesale
clients. Typical services of commercial banks to households and SME’s are acceptance
and repayment of deposits from which banks make commercial, consumer and mortgage
loans. In addition, they provide different kind of payment services like bank cards, credit
cards and e-banking. The services offered to big corporate clients are similaralthough the
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 14
type of services provided by corporate banking divisions of financial institutions are much
more extensive.
Other types of retail banks
In the retail sector, in addition to commercial banks there are also some other financial
institutions where you can keep a deposit (sometimes also referred to as ‘thrift
institutions’). In the US especially, Savings and Loan’s (S&L) banks are an important
banking institution. They obtain funds through deposits, and use these mainly to provide
long-term mortgage loans. Mutual savings banks operate similarly. However, their
organizational structure is quite different, since the depositors own the bank. Finally, credit
unions are small cooperative deposit institutions that are often organized around a union
or a firm. They obtain funds by issuing deposits and use these to make particularly
consumer loans.
Trends and critical issues
Market Segmentation
Studies show that 20% of the customers at retail and commercial banks generate
as much as 200 percent of the profits whilst the remaining customers actually
undercut profits.
2
In response, many banks in western countries in the 1990’s
decided to divide up their services around the customer, rather than around
products or channels, according to the profits made from various client types.
3
Clients, regardless of whether they are received in person, through the internet or
call centres, are then dealt with according to a pre-set level of services, fees, and
privileges.
4
Services to the ‘poor’ have been drastically cut whilst services to small
and medium-sized enterprises (SMEs) are much less than to those for the larger
corporations.
Closing branches and opening redesigned branches
Market segmentation has also resulted in closing and streamlining branches in
most western countries. Those remaining branches focus on selling financial
products, which earn more profit (i.e. loans) from richer clients. Call centres and
automatic tellers, which replace branch staff, often leave the client wondering if
"there’s anybody out there?". In the Netherlands, the amount of bank branches
was reduced by 40% in 5 years, i.e. from 7 000 in 1998 to 4109 in 2003.
5
Many banks have been losing clients due to the downgrading of retail services but
in the last year or so in some cases, client contact has been re-valued and steps
have been taken to improve human-to-human contact. Clients of Barclays and
HSBC in the UK and others should watch out for the new branch trend, which is
all about "eye contact" and offering a "library" setting, where you can sip coffee
and read promotional brochures. Even though the redesign is aimed at increasing
customer satisfaction, cutting costs to increase revenues means you will still have
to do many transactions yourself.
6
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 15
Reducing direct services for the poorer
In line with market segmentation and cost cutting or profit opportunities, banks are
pushing or obliging customers to use cheaper automated services or automated
channels such as the internet or automatic money distributors (ATMs) for
transactions on one’s personal account. For example, in the Netherlands cash
dispensers on the street must be used to withdraw Euro 500 or less, which is a
problem for many including the elderly.
Many European banks in 2001 intended to switch the 80% of the least profitable
clients to automatic channels for low added-value transactions, and at the same
time sell to these clients different products through the internet.
7
One tactic to
persuade people to use the automated services is to offer better interest rates on
deposits made on the internet, even though e-finance is not yet fully secure.
Sometimes banks exclude the very poor
8
from services by, for example,
identifying city areas, or “red-lining” areas, on the map considered poor, where
banks refuse to provide certain financial services. And within these areas low-
income households do not have access to mortgage loans.
9
In developing countries, the very poor often have no access to saving accounts or
they have to pay for them. Those already excluded from society, the marginalized
and poor, are often excluded even further due to their lack of access to basic
financial services and most countries don’t have laws obliging banks to provide
access to basic services.
Cross selling
Banks distribute other financial products to clients through existing branches,
including insurance products and policies, and mutual funds.
Customer’s choice?
Theoretically consumers can freely choose and change their retail banks but in
some cases it is not possible to retain account numbers when changing banks,
which makes changing banks less interesting. New laws in some Western
countries allow customers to keep their account number if they switch, which is
intended to increase competition and improve customer customer service.
10
Run on the banks
When clients loose trust in their bank, fearing that it will go bankrupt, they run on
the bank, to get their money out. Since banks do not actually have all their clients’
savings in the vaults available for full withdrawal at any one time, clients' ‘running
on the bank’ could result in the bank collapsing or exacerbating an wider, existing
banking crisis.
The risk of a run on the banks is still a problem in developing countries as was the
case in Argentina during the financial crisis from 2001 onwards and in Zimbabwe
in January 2004.
11
In some countries, foreign banks are often trusted more, but it
is the richer people who can afford their more expensive services. Not all
countries require banks to have a deposit insurance system, which guarantees
the repayment of at least some of the clients' savings.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 16
Transfer of migrant remittances
The cash sent home by migrant workers, in many developing countries, exceeds
the capital inflow from foreign direct investment. Traditionally these transfers were
sent by money order, which had high commission fees. In 2001, the US Treasury
registered more than $1bn commissions made by migrant workers.
The surge in electronic transfers has allowed more financial firms to enter into this
oligopolistic financial service sector, thus increasing competition, which has lead
to a drop in commission fees. At the same time, migrant workers can more easily
send smaller sums of money back home.
12
1.1.2 Lending of all types and related services
For many banks, offering loans is a significant business and is one of the ways the bank
actually creates money. Loans can take many forms (credit cards included) and can go to
individuals, companies, other banks (or inter-bank lending), large projects, governments or
governmental organizations.
Mortgage banking
When a bank sells a loan for real estate, sometimes combined with insurance and mutual
funds, they are selling a mortgage. The bank’s revenue comes from the commission fees
and servicing the debt (loan servicing) by way of interest payments, and sometimes from
the resale of the loan to other investors.
Project lending
Project loans refer to loans for big projects by governments or corporations for the
construction of infrastructure including oil pipelines, powerhouses and dams. These loans
often contain loan covenants or agreements between the lender and the borrower about
what the borrower should or should not do, such as regular reporting, adequate insurance
and asset reserves.
Trends
Syndicated loans
Syndicated loans are loans for large risky commercial projects or for governments
and are financed through a group of banks and other financial institutions called a
bank consortium or a syndicate. The bank coordinating the consortium and the
syndicated loan could be different from the banks’ providing the loans in the
consortium.
Credit risk mitigation
Banks have mechanisms, through credit derivatives and credit securitization (see
below), which they use to spread out the actual risks of the loans and credit. Risk
mitigation instruments are used by banks which concentrate credit in certain
sectors of their expertise and are vulnerable to heavy losses should the particular
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 17
sector take an economic downturn. Risk mitigation instruments are considered by
some as being one of the reasons Brazil was affected by the Asian financial crisis
in 1997-98.
Credit risk mitigation instruments are contracts that are mostly traded13 between
bankers and investors. The credit derivative market was estimated at $ 40 bn
(outstanding notional value) in 1996 and $ 1.2 trillion at the end of 2001. The
massive growth is expected to continue and to reach an outstanding notional
value of $ 4.8 trillion by the end of 2004.
14
Credit derivatives
Relatively new to the commercial banking sector, but on the rise over the past 5
years, a credit derivative
15
is a contract between two parties that allows for the
use of a derivative to transfer credit risk from one party to another. The derivative
is based on a credit, either a loan or bond in most situations.
The derivative contract stipulates the fees the two parties pay each other,
depending on the kind of derivative and the risks (e.g. non repayment of the loan)
covered. The protection buyer, most often the bank, remains the owner of the
original loan.
The most common credit derivatives are credit default swaps
16
which are
agreements where credit risk and fees of a third party are transferred from one
party to the other. The first party in the swap is a lender and faces credit risk from
a third party. The counter-party (or the protection seller) in the credit default swap
agrees to insure the default risk in exchange of being paid regular periodic
payments (i.e. essentially an insurance premium).
If the third party defaults, the second party assuming the risk will have to
purchase from the first party the defaulted asset. In turn the protection seller pays
the protection buyer the remaining interest on the debt as well as the principal.
Other forms of credit derivatives are total-return swaps, and credit-spread put
option contracts. The number of types of credit derivatives that are traded among
protection buyers and risk sellers is ever increasing.
Securitization
Securitization involves the packaging of debt (like loans or mortgages), which
generates predictable cash flows, in a pool and selling these to investors in the
form of securities. Securitization is a relatively new but fast growing form of debt
financing. Over a period of 20 years, securitization became one of the largest
sources of debt financing (or credit provision instrument) in the US and is also on
the rise in Europe and Asia.
The securitization of (bad) loans and other debt instruments means the credit
risks is removed from the bank or loan provider and is spread among the buyers
of the securities. As a consequence, it becomes unclear exactly who assumes the
risks. However, the point is that the bank that provides the loan, does not have to
deal with bad debts
17
.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 18
Project finance
Project finance refers to finance especially directed to big, mostly infrastructure projects like oil
pipelines, hydroelectric dams and telecommunication infrastructure. After massive privatization
and deregulation of industrial sectors, since the early 1990’s, private sector financing of these
projects has grown enormously.
It is a form of credit that responds to the particular characteristics of large projects. The initial
costs of the big projects are very high, while the benefits can only be reaped in the longer term.
All kinds of risks are involved (financial, environmental, political etc.), and therefore project
finance has evolved to be a very complex issue. Finance for big projects can take two forms:
equity and debt. If the risks of the projects are high, a substantial percentage of the finance is
provided through equity arrangements, that is, those financiers “own” the project, and thus also
will bear the costs in case of a failure of the project. Other financiers often require a high level
of equity finance, because the existence of a substantial group of shareholders will increase the
real commitment to the success of the project.
If the risks are perceived smaller, there is normally more debt finance. Debt finance again, can
take two forms: loans and bonds. Project loans are made by commercial banks and normally
contain loan covenants or agreements between the lender and the borrower about what the
borrower should or should not do, such as regular reporting, adequate insurance and asset
reserves.
Increasingly, projects are also financed through project bonds. Banks then assist the company
or government in attracting private funds, by underwriting project bonds. (for underwriting, see
section 1.2) Like with project loans, in the issue of project bonds the terms of the agreement
are included in a bond covenant.
Although governments have left the financing increasingly to the private sector, they remain
involved in the design and the conditions of the projects. Local governments can be involved as
a contracting party that will buy the infrastructure after the project has been finished. Host
governments of the construction companies can be involved when their Export Credit Agencies
(ECA’s, see section 1.4) offer insurance for the payment of their activities. Also, taking into
account the enormous risks involved in some projects, participants often require the
involvement of multilateral development banks like the European Bank for Reconstruction and
Development or the International Finance Corporation (the World Bank’s private arm) to back
the project. As a result, project finance often takes the form of hybrid public-private
partnerships.
Social movements are increasingly concerned with the impact that financial lending, to
companies and for projects, has on the environment and human rights. Current project lending
often results in unsustainable practices because financiers do not produce reasonable
environmental and social impact assessments of the projects they are financing. The lack of
sustainability criteria and regulation combined with the lack of transparency for those individual
‘savers’ (who are interested in knowing how the bank is using their savings) and channels for
those savers to voice their concerns also leads to unsustainable practices. This issue is further
discussed below (Chapter 4).
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 19
Critical issues in lending services
Credit to small and medium entreprises (SME’s) lacking and too expensive
Most financial firms see lending to SMEs as a high risk and administratively
costly, which mean SMEs have less access to credit and the interest rates they
pay are higher than what larger corporations are offered. Yet, SMEs are often the
most dynamic and innovative segment of many countries and provide the bulk of
employment. This problem is sometimes recognized at the national or
international levels but it has not been successfully resolved.
To promote economic growth and reduce escalating poverty, delegates at the
Summit of the Americas in January 2004, called for the promotion of small credits
to individuals and small producers.
18
Ironically, the Summit also called for more
free trade. It is exactly the fierce competition within the financial service sector, as
a result of free trade, that has lead to SMEs being denied credit due to their high
costs and perceived risks. For example, in Mexico, the entry of foreign banks has
not lead to the improvement of the banking sector as many had hoped. Foreign
banks, especially Spanish and US ones, now control 80% of the banking sector.
Although rich clients in generally are being served well, households and SME’s
have a hard time getting loans from these banks. This situation has led the
Mexican central bank and politicians to publicly raise concerns, since foreign
banks are often also harder to regulate than domestic ones. Under the current
climate, it is unlikely that more credit will become available to SMEs without
government intervention and support. The World Bank has started trainings, with
Citigroup, to promote the financing of SMEs in Latin America
Minorities have less access
Research has revealed that African-Caribbean businesses have extra difficulties
in the UK accessing finance due to discrimination and a lack of trust.
19
Some
banks around the world promote ethnic banking to attract the minority and
immigrant clients, however gaps remain between bank policies and
implementation.
Predatory lending
In some countries, banks and other financial firms aggressively sell easy loans
with high interest rates designed specifically to exploit vulnerable and
unsophisticated borrowers. People in metropolitan areas in the US -including
minorities, low and middle income borrowers, women and others excluded from
mainstream credit- are particularly targeted and victimized by predatory lending
and high interest rates, which further marginalizes these groups in society.
20
Existing laws do not protect these vulnerable members of society but rather
sanction predatory lenders.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 20
Credit cards
Credit cards provide easy access to advanced payment and credit at home and
abroad. They make payments easier for the business sector and those who travel
because they avoid having to carry large amounts of money or foreign currency.
However, they have also severely increased indebtedness. The interest rates,
which are paid when payment is not immediate upon receiving the bill, are higher
than for credit from banks.
The level of personal indebtedness due to credit cards has reached crisis levels in
various countries including the US and UK because credit card holders purchase
items they can’t afford otherwise. In South Korea where credit cards have been
made readily available and consumption has been encouraged by governmental
incentives, many clients were unable to repay their debts when the economy
slowed down (US$ 5.8bn of unpaid bills in September 2003).
21
The government
has had to intervene at the end of 2003 in order to prevent credit card providers
from collapsing, thus affecting the whole South Korean banking system.
22
At the same time, credit cards are marketed in increasingly attractive ways. They
target specific groups like the young, who they hope will fall into debt at an early
age, thus remain lifelong credit card customers. Visa designed a mini-credit card
for young Asian consumers that attaches to a necklace or a bracelet.
23
In order to
attract customers, affinity credit cards are offered and allow customers support
charitable causes through their payments.
Non-banking financial services
Increasingly companies that do not offer financial services in their core business
(i.e. supermarkets) have started selling credit products as well as credit card
services. For example, in Canada the big chain supermarkets now have ‘banks’
on site, which can arrange a loan, a mortgage and take care of your savings.
They are getting into the financial service industry because they want to keep
their shopping customers and create a ‘one stop shopping/banking’ experience.
Debt market
When developing countries have problems paying back their loans, sometimes
the debt is written off from the lending banks' books (through bad loan provisions),
and/or sold by the lender, at a reduced price, to another financial service provider,
who then tries to recover the whole loan. This means that developing countries
are pressed to repay their loans while the lenders have already written off or
reduced the value of the loan.
Banks and other international financial firms that lend to developing countries
come together in informal networks like the "London Club" when repayment
problems occur. They collectively look with the defaulting developing countries at
repayment strategies, but generally this benefits the banks the most.
Credit risk mitigation products create new risks
Credit risk mitigation products, like credit derivatives, transfer the credit risk away
from banks to third parties. Perhaps this is why banks survived the rough
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 21
financial patch from 2001-2002 where loan defaults increased because the
economy slowed down and the stock markets dropped, and where the financial
capacity of many individuals and corporations was weakened.
However, regulators and experts worry that these credit mitigation mechanisms
could destabilize the banking system because:
The access to credit risk mitigation instruments might encourage the
credit providers to take more risks, or to be less prudent in assessing and
monitoring borrowers after the credit contract is signed.
24
Too many bad
loans might increase banks' risks and lead to destabilizing the banking
system
25
, the opposite of what risk mitigation instruments attempt to do.
Currently supervisors are afraid of unchecked, concentrated
accumulation of credit risk.
26
It is not fully clear to regulators where all the
risks are being transferred to, and the possible consequences. Especially
insurance companies are active buyers of credit derivatives, and thus
indirectly sell banks protection against credit loss. Mutual and pension
funds have also heavily invested in these instruments
27
. Defaults on
loans will now thus potentially endanger the financial position of these
investors (and the households whose money they manage).
The pricing of credit derivative contracts are complex to calculate and
document, and all the potentially important factors might not be included
in the model that calculates the risk,
28
upon which the derivatives are
based, resulting in some unexpected and heavy losses for the buyer.
More borrowing through low interest rates
Banks providing consumer credit and loans for housing or business profited in
2003 when the interest rates in many (western) countries were at a record low.
Low interest rates means credit is cheap and therefore more people tend to take
out loans. Banks profit from high lending despite the relatively small profit margins
from the difference between interest rates banks provide for savings accounts
and the interest rates they earn from lending. The problem is that when interest
rates increase, the rates for existing loans will also increase and the cost for
servicing the debt increases. If lending has been arranged without a careful
assessment of an individual or company’s payment capacity in a worse case
scenario, the banks might be left with bad loans.
29
This could undermine the
bank’s profitability, which undermines services for clients, the bank as a whole
and potentially the whole economy.
Micro-credit financing
Because large national and foreign banks are not interested in providing small
amounts of credit, micro-credit schemes have begun to flourish in poor and low
income areas.
The spreading of the micro-credit institutions, like the Grameen Bank, indicates
that there is a great demand for small amounts of credit and their payback
success rate indicates that low-income people can be a good credit risk.
Alternative banks and investment schemes try to provide the capital micro-credit
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 22
institutions require. The World Bank and even mainstream banks have
bourgeoning interest in micro credit.
For example, ABN Amro opened a micro-credit division in Brazil. It has however
been faced with the problem of selling the micro-credit product (loans) to weary
and suspicious entrepreneurs in the informal economy. ABN Amro wants the
micro-credit project to be profitable within 2 years.
30
There are many dilemmas
when large donors and mainstream bankers and investors get involved. The
benefits and the disadvantages have to be carefully weighed in order to judge
whether this mainstreaming is the best way to support poverty eradication.
Lending practices that undermine the economy: “Tanzi finance”
Financing of companies is changing from a system whereby repayment of loans and interests
is done through cash flows, to a more speculative financing system whereby only interest can
be paid through cash flows. In adverse circumstances, the companies have to sell some of
their assets to repay loans. There are more and more cases whereby the companies are
unable to meet their interest and principal repayment obligations from their cash flows (“Ponzi
finance”, after an Italian swindler called Charles Ponzi). They need to constantly raise new
funds, often through hidden or innovative systems, which can cause the company to collapse
under its debt burden (“Tanzi finance” after the owner of Parmalat, the collapsed dairy
multinational).
This more speculative financing is made possible through banks and other financial firms that
seek to make profits from more and more financing mechanisms, and increase their leverage
on the economy from the constant need for more finance.
An economy dominated by such speculative ‘ponzi financing’ supported by financial firms
becomes fragile and susceptible to a financial crisis. Such an economy is dependent on
continuing asset price inflation and larger amounts of credits. Small raises in interest rates or
declining company incomes might cause problems and compel companies to sell their assets.
When too many companies are in such financial trouble, the economy collapses as in the
1930s. Authorities can intervene, as the US has been doing for instance when the stock market
crashed (1987) or imploded (2001-2002), and during the saving and loans crisis (late 1980s).
But such intervention is encouraging more ‘Ponzi finance’ to a point where too much debt is
beyond salvation.
In the case of the collapse of Parmalat, special schemes –often designed by financial firms-
were used to hide the debt from investors, such as: ”bank loans rendered safe with credit
default insurance, asset-backed securities collateralised with fake invoices, credit-linked notes
which allowed the issuer to bet on its own creditworthiness, bonds which by secret covenant
varied the coupons payable according to the company's interest cover, liabilities sliced up and
distributed in collateralised debt obligations, and a myriad of finance company subsidiaries
registered in off-shore tax havens”.
Source: M. Vander Stichele, based on E. Chancellor, The perils of Tanzi finance, 22 February 2004,
at www.prudentbear.com
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 23
1.2 Services related to securities and asset management
Financial firms profit, i.e. make money, through financial products dealing with securities
including the issuing, trading and managing of securities. In addition, financial firms trade
and manage various other assets such as savings, foreign currencies, real estate,
commodities and gold.
1.2.1 Investment banking
Unlike traditional banks, investment banks do not accept deposits from, nor provide loans
to, individuals.
a. An investment bank is an institution that acts as an underwriter or agent for
companies or governments issuing securities (bonds and shares). The services of an
investment bank support the introduction of new shares to the (stock) market.
By underwriting, the investment bank buys all the new securities from the
issuer (a company, a government) at an agreed upon fee, thus the issuer
is guaranteed a certain minimum amount raised from the issue, while the
underwriter bears the risk. The underwriter then resells the new shares
directly to the market or to another investor. The underwriter guarantees
to buy any shares which are not bought by the public (which creates
public confidence). The profit for the underwriter is in the difference
between the price paid to the issuer and the public offering, which is
called the underwriting spread.
The investment bankers' role begins with pre-underwriting counseling
and goes on with pricing of the securities, stabilising the price of the issue
during the offering, and often continues after the distribution of securities
is completed, in the form of ongoing expert advice and guidance, often
including a seat on the board of directors of the company, and stabilising
the price of the security during the distribution period. Investment bankers
can also form an underwriting group, which pools and therefore
distributes the risk.
In other arrangements, investment bankers market a new issue without
underwriting it, acting as agent, and taking a commission for whatever
amount of securities the banker succeeds in marketing.
b. Investment banks play a large role in facilitating mergers, acquisitions and corporate
restructuring through advice (in return for high fees) and financing.
c. Investment banking also deals with converting loans and other assets into securities
(securitization).
The investment banking industry is roughly divided between those clients with more than
$ 1 bn in revenue, those in the middle market, and those in the smaller market with
revenues of around $ 25 million.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 24
Trends
Less business after the dotcom bubble burst
During the economic and stock market downturn of 2001-2002, fewer businesses
were interested in issuing new shares, which resulted in less income for
investment banks. Just prior to the slump, investment banks were increasingly
selling new shares particularly from those IT (information technology) companies,
which helped create the dot.com bubble. In 2004, after three years of
retrenchment, investment banking saw a rise in business again, party due to an
increase in equity underwriting.
31
More bonds
Issuing corporate bonds has been on the rise as investors are weary of the
unstable income from stock markets in recent years.
32
Moreover, bonds have
become a major instrument for corporations to raise capital rather than going to
the bank for loans. Companies that were at edge of bankruptcy have been issuing
junk bonds which were bought by investors willing to take high risks of losses in
case of bankruptcies, with sometimes high returns if the companies recovered.
33
Slow down and rise of mergers and acquisitions (M&A)
Many investment banks strongly promoted multi-billion dollar M&A, which during
the boom years inflated the stock market, and earned these investment banks
huge profits. Some financial conglomerates expanded their investment banking
operations during the ‘high’ times, at the expense of retail banking.
The benefits of M&As are not always obvious as many companies are left with
massive debts that are difficult to repay in an economic downturn (e.g. Vivendi),
while research shows that problems with merging corporate cultures and
management systems is known to contribute to more than 60% merger failure
rate. Recent corporate scandals at Ahold and Parmalat are, in some circles,
considered a consequence of expanding too quickly through M&A. Recently,
mergers and acquisitions have been on the rise again. In 2004, M&A were at the
highest levels since 2000, and this trend is likely to continue in 2005.
34
Prospectus with insufficient information
Investment banks offer a share prospectus to the public when shares are issued.
Due to problems of insufficient information for potential investors to assess the
price and value of the shares, more and more regulations have been legislated to
guarantee that investors are warned against the potential risks of losses.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 25
The role of banks in the collapse of Parmalat
Parmalat has been one of the world biggest dairy and food groups, with headquarters in Italy.
Its rapid expansion worldwide was first financed by loans from Italian and international banks.
Once the debt became too high, Italian and international banks arranged for issuing Parmalat
bonds. In December 2003, Parmalat could not repay its financial obligations and it became
slowly clear that it had been hiding losses and financial malpractices which are estimated at
more than Euro 12 bn.
Beginning 2004, Citigroup, Bank of America, Deutsche Bank and Morgan Stanley were being
accused of colluding with Parmalat executives in a scheme to hide the dairy group's massive
debt in order to inflate the value of the company's securities and bonds underwritten by the
banks.
35
The banks lay blame on the accountants' wrong financial reports, which inform banks
for their decisions.
36
In total, some 20 investment banks were involved in 40 bond issues mostly
through unregulated trusts in the Netherlands. They raised around $ 9 bn for Parmalat in 10
years from large and small investors.
An Italian executive of Bank of America is under investigation for having provided false
documents that informed accountants about an account that did not exist, and having set up
trusts that bought up the unsubscribed portions of private bond placements (to increase their
value).
37
Parmalat had different trusts in off shore centres.
Italian banks were by law not allowed to sell bonds to individual investors if those bonds were
issued only for institutional investors. However, the Italian banks were allowed to include those
Parmalat bonds in their mutual funds, which were bought by individual investors.
38
When
Parmalat collapsed, many Italians saw the value of their savings disappear.
Beginning 2004, some banks started to write off some of Parmalat's debt. Citigroup has set
aside $ 242 million for credit and trading losses (after taxes) related to Parmalat in 2003. The
total credits to Parmalat amounted to $ 653 million
39
but Citigroup had transferred the credit
risks to others for about half the amount.
In 2005, investigations were still taking place. Italian prosecutors were planning to bring to trial
Citigroup, Morgan Stanley, Deutsche Bank, UBS and the asset management arm of Banca
Intesa, for misleading investors and regulators in providing false information on Parmalat’s
financial position.
40
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 26
Critical issues
World Bank bonds
Many investment banks underwrite World Bank bonds, which are bought by
institutional investors including pension funds or funds managed by banks. The
World Bank gets 80% of its funds from the selling of its bonds. Many civil society
groups criticize World Bank’s “structural adjustment” programs that make World
Bank loans to developing countries conditional to all kinds of questionable
policies. A special network has been established to boycott the World Bank bonds
issues on private capital markets
41
.
Conflicts of interest between investment banking side and analyst side of
banks
Banks that underwrite and deal in issuing securities are often the same banks that
provide asset management services and advisory services to individuals or
institutional investors who buy securities. It has become apparent, after years of
rising stock markets, that some investment banks that assumed this dual role
have been misleading investors with biased research in order to win clients (see
box).
42
Some CEOs have been offered better-priced securities of new issues if they
bought additional banking services from the investment bank. Remember having
issued new shares, underwriters occasionally become members of the board,
which suggests closeness between the underwriters and the board of directors.
Investment banks, with inside knowledge of corporations, also reap the rewards
of high stock prices as well as of dumping shares in due time before they loose
their value, while the shareholding public is often left holding worthless paper.
Bursting of the dot-com bubbl
The stock market decline over 2001-2002 set the stage for growing queries regarding how
investment banks valued shares and how analysts from leading financial conglomerates
advised them. It was the collapse of energy trading company Enron at the end of 2001
that set off alarm bells due to falsification of balance sheets and corporate cover-ups by
one of the biggest auditors Andersen.
The scandal opened a floodgate of investigations into the overall standards and practices
of the American financial services industry, which drew into the fold the big auditors and
rating agencies. The world top investment banks such as Citigroup, Goldman Sachs, J.P.
Morgan and Morgan Stanley were fined huge amounts of money, paid in 2003, together
totalling more than $ 1.4 bn
43
, for conflicts of interest and generally misleading investors in
the US (see box). The banks had to restructure their operations and sever the analyst
division from the investment bank division by erecting a “Chinese Wall” to ensure the two
service divisions and employees never collude, and avoid further conflicts of interest and
corporate crime. Also in Europe, new rules and ways of operation for analysts have been
discussed.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 27
Scandals at financial firms
Manipulating the stock market
44
Citigroup, Goldman Sachs, J.P. Morgan, Morgan Stanley, Merrill Lynch and other top banks
paid a fine of US$ 1.43 bn to the US Securities and Exchange Commission (SEC) in April 2003
for the following malpractices in their investment bank services:
Conflict of interests: banks' securities analysts under pressure from colleagues to give
favourable advise to investors to buy shares from companies that were worth much less but
that were clients of other units of the bank. The favourable advise was a means to get, from
those companies, new highly profitable mandates for the investment bank unit to introduce new
shares or give advice on mergers and acquisitions.
Flipping: allocating new shares to a limited number of investors, and then selling those scarce
and highly demanded shares to the public, with high profits.
Laddering: the investment bank underwriting or introducing new shares requires brokers to buy
the new shares shortly after their introduction in order to keep their value high. In return, the
brokers are allocated extra new shares during the next introduction of shares. This kept the
value of shares, especially high tech shares, artificially high.
As a result of manipulating the stock market, shareholder wealth was reduced by 45% between
March 2000 and end of 2002, the equivalent of half of US GNP in 2000.
45
Manipulating bond markets
In the beginning of 2005, it became known that Citigroup had been involved in a major financial
scandal in August 2004. It had sold eurozone bonds worth of €12 bn, causing the prices to fall
dramatically. Traders of the bank later bought some bonds back at € 4bn, and this operation is
estimated to have made the bank a €17 million profit. Citigroup’s actions prompted criminal
investigations in Germany, and possibly inquiries in other countries follow. Citigroup has
apologized for the impact the trades had on financial markets, but claimed the deal “did not
violate any applicable rules or regulations”.
46
In March 2005, German prosecutors claimed they
could not legally establish a charge against Citigroup, since had to prove “an intent to deceive”,
and this had not been possible. Under a new German law on investor protection, which was
recently introduced, it will probably become easier to punish comparable actions
47
.
Undue privileges to rich clients (“spinning”)
Investment banks that introduced new shares gave CEOs of their client companies preferred
access to the new shares (from which the CEO could make personal gains) in return of new
investment banking mandates. For instance, in January 2002 Credit Suisse First Boston
48
paid
US$ 100 million to settle charges of this malpractice which has also been reported around the
world at many other banks.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 28
Bank malpractices at Bank of America (BoA), just an example
49
Failure to provide documents to the supervisors: the SEC fined a $ 10 m penalty in March 2004
because the bank provided misinformation and delayed or failed to produce documents
requested by the SEC for its investigation of illegal trading by the bank.
Alleged illegal trading in equities: the BoA was investigated beginning 2004 for allegedly taking
advantage of knowing future equity price movements that would follow the publication of equity
research briefings made by the bank’s own staff. By trading itself in equities just before the
publication of the research briefings, it could take advantage of its (insider) knowledge and
make extra profits.
BoA is being investigated by the SEC for allowing a client, a hedge fund, rapid trading practices
by lending its software to the client (see below: mutual fund scandals).
Parmalat: BoA was the house banker of the collapsed Parmalat and was involved in
fraudulently hiding Parmalat's huge debt through false statements (see box about Parmalat
scandal).
Developing countries pressured to sell too many bonds
Governments of many developing countries issue bonds to finance their deficits
and development plans. They are advised and sometimes pressured by
investment banks. After the 1997 financial crisis and after the IMF programme
was completed in 2003 the banks began to pressure the Indonesian government
to issue higher volumes of bonds, but the government hesitated for fear of
destabilizing the recovery with more debt.
50
Banks issue government bonds even in times of financial difficulty or crisis, which
raises questions as to whether banks properly assess the repayment capacities of
these governments. If the debts become too high and governments cannot repay
the bonds in due time, bond investors are pressuring to have payment of their
bonds prioritized. With no international agreement on orderly bond debt
restructuring or cancellation, the economy and poor people of a country suffer
most from the bond repayment obligations.
1.2.2. Private equity firms
51
Like investment banks, private equity firms raise funds for companies from private
investors. In contrast to the traditional operations of investment banks, they do not raise
money on public stock markets, but through direct intermediation between companies and
investors. Wealthy individuals or institutional investors like pension funds can invest their
money in a private equity fund, which the management directs towards companies. Many
large (investment) banks now have their private equity divisions. Their activities can be
divided in two main categories:
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 29
- Buy-outs: the buying of (parts of) companies that they perceive to be undervalued by
other investors, often because of troubles the company is facing, Private equity firms then
buy those companies, reorganize them with the aim of selling them at a higher price.
- Venture capital: the finance of starting companies often in fast-growing sectors.
Trends & Critical Issues
Major growth
The private equity market has grown enormously since the 1990s. In 2001, global
private equity investments market were at just below $ 100bn; in 2004, they had
risen to just over $ 300 bn. European investments accounted for half of the
investments, the US followed.
52
What about accountability?
Through buy-outs, private equity firms buy firms of the stock market and get direct
control over the management of companies. What happens in the company
owned by a private equity firm is much less public than publicly listed companies,
for example due to the absence of disclosure requirements for privately owned
firms. Some have expressed their concerns over the lack of accountability as a
result. The private equity management can change the staff and personnel much
easier than would be possible in a company listed at the stock market, since there
are no shareholders they have to explain there policy to.
53
1.2.3 Research, trading and brokerage
All kinds of firms are active in the intermediation of buyers and seller of securities. For
example, analyst houses and various research departments from financial firms sell their
services to investors who trade in securities or other assets including currencies, gold and
commodities. Financial firms also sell various trading services including executing orders
to trade and clearing securities trading.
Stock exchanges
It should be remembered that stock markets are also privately owned companies.
Worldwide, there are hundreds of exchanges. In practice, a few of them dominate global
markets, including the New York Stock exchange, the NASDAQ, the London Stock
Exchange, Frankfurt’s Deutsche Börse in, Euronext and Tokyo’s Stock Exchange
54
. As a
result of the globalisation of capital markets, and the increased competition from purely
electronic trading, there have been incentives for stock markets to cooperate or merge
with others. The Amsterdam, Paris and Brussels stock exchanges already merged into
Euronext. In the beginning of 2005, there has been much speculation on what is going to
happen with the London Stock exchange; Deutsche Börse and Euronext were contesting
a takeover.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 30
Critical Issues
Risks of stock exchange consolidation
The consolidation in the stock exchanges is said to bring more liquidity through
larger markets, and so increase efficiency. However, some have expressed their
concerns about the current mergers and takeovers. For example, some fear that
through a takeover of the London Stock exchange, competition on the European
continent between different stock exchanges will disappear, so that the prices for
– especially smaller - securities traders could increase. There should thus be
more supervision on stock exchanges at the European level, to guarantee a level
playing field
55
. The British Financial Services Authority expressed its concerns
over a possible takeover, since the London exchange could be moved to another
jurisdiction. In that case, other regulations would apply, and this could jeopardize
the current safeguards in place that protect both investors and companies listed
on the exchange
56
.
Brokerage
Brokerage houses and brokers within financial firms are intermediaries between a buyer
and a seller and usually charge a commission. A broker who specializes in stocks, bonds,
commodities, or options acts as an agent and must be registered with the exchange
where the securities are traded (i.e. requires a license).
Trends and critical issues
Bias and market players
The research and analysis divisions of banks played an important role in
overvaluing and promoting certain securities, thus artificially inflating the stock
market, which has been dropping in a "slow crash" since end of 2001 (see box
above).
Profit even in bad times
Banks that offer brokerage services even profit when the stock market falls due to
the commissions they receive for selling orders from investors. During the Asian
financial crisis, the profits from securities' trading divisions of Dutch banks actually
increased.
57
High salaries & bonuses
The exorbitant salaries and bonuses of those in the securities business have
been increasingly criticized, but to date, have never been addressed through
regulation. The difference between what traders and investors earn (those jobs
which are securities related) and those workers providing basic public services,
upon which a society is based, like teaching and nursing, reflects a serious,
ethical imbalance.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 31
Security lending
Securities are leased or lent to investors who then try to make a profit by trading
the leased security within the time of the leasing. Often leasing is done with
borrowed money, which can result in huge losses if the trading is not profitable. In
the Netherlands, for example, at the peak of the stock markets, there were
700.000 lease contracts outstanding, totaling an amount of € 6,5 billion. Many
investors faced enormous losses when the stock markets collapsed. Total losses
have been estimated at almost € 3 billion. The duped investors claimed they had
not been sufficiently informed about the risks informed. After a lawsuit, two
financial firms involved in the lease sales, had to pay almost € 1 billion
compensation to the investors.
58
1.2.4 Derivatives services
Financial firms earn fees and are paid premiums for designing and trading in derivatives.
Derivatives are speculative contracts, whose value is derived from the future trade in an
underlying commodity, security or other financial asset. Examples of derivatives are
futures, options and swaps.
Derivatives bet against what a contract will be valued in the future. It offers for instance
protection against changes in commodity prices. Depending on the derivative, traders and
buyers take into account the performance of the asset, interest rates, currency rates and
various domestic and foreign indexes.
Because derivatives are both physically and temporally several stages removed from the
actual underlying commodities or financial instruments, to the outsider, they can be very
complicated in nature. Research found that institutional investors have an insufficient
understanding of the way companies use financial derivatives.
59
Banks offer completely
custom made products by which the client is free to determine the derivative, using
variations in underlying currency, time to maturity, and payout structure (exotic options).
Options
On option is the right, but not the obligation, to buy (call option) or sell (put option) a
specific amount of given stock, commodity, currency, index or debt at a specific price (the
strike price) during a specific period of time. For stock options the amount is usually 100
shares. Each option has a buyer (called a holder) and a seller (known as the writer).
The buyer of such a right has to pay a premium to the issuer of the derivative (i.e. the
bank) and hopes the prices of the underlying commodity or financial asset to change so
that he can recover the premium cost. The buyer may choose whether or not to exercise
the option by the set date.
In practice, most call and put options are rarely exercised and investors sell or buy options
before expiration, speculating on the rise and fall of premium prices. For instance, when a
put option is exercised (e.g. at $50 a share) and the price of the underlying asset is much
lower in the market (e.g. $30 a share) at that time, the one with the right to sell can sell
and than re-buy the underlying asset at a lower price, making a profit (e.g. $20). Often,
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 32
option traders lose many premiums on unsuccessful trades before they make a very
profitable trade.
Futures
A future is a contract to buy or sell a specific amount of commodity, a currency, bond or
stock at a particular price on a stipulated future date. A future contract obligates the buyer
to purchase or the seller to sell, unless the contract is sold to another before settlement
date, which happens if a trader speculates to make a profit or wants to avoid a loss.
Currency swap
Simple currency swaps (swaps can be done with varying degrees of complexity) involve
two parties exchanging specific amounts of different currencies, as well as the interest
payments on the initial cash. Often one party pays a fixed interest rate while the other
pays a floating exchange rate. At the maturity of the deal the principal amounts are paid
back.
It allows the party, which is to receive currency in the future to calculate exactly what to
receive and avoiding exchange rate fluctuations. Swaps are also used to tap into new
capItal markets, sell currencIes on the InternatIonal market and borrow funds.
"Over the counter” (OTC) trading in derivatives
Over the counter derivatives trading is an exchange directly between the buyer and seller.
It is not listed on the exchange and is not traded through third parties.
Critical issues
Volatile business
Unexpected movements in the underlying value can negatively affect the value of
the derivatives. Derivatives became notorious in 1990s when a number of mutual
funds, municipalities, corporations and leading banks suffered large losses
because unexpected changes in interest rates affected the value of derivatives.
The trade in derivatives can have enormously destabilising effects on local
economies, because the use of derivatives allows speculators to move enormous
funds without actually owning them. In 1997, speculators used derivatives to
launch an attack on the Hong Kong dollar peg to the US dollar. They did this by
buying up large amounts of both foreign exchange derivatives and equity
derivatives with the aim of driving up interest rates and driving down share prices,
and ultimately breaking the peg, making them enormous profits. In the end, the
peg didn’t break due to Hong Kong authorities’ intervention in the equity and
foreign exchange markets
60
.
Lack of regulation
Much of the trade in derivatives takes place in over the counter (OTC) markets, in
which there are often no transparency requirements in place. Governments and
market participants have thus no way of finding out manipulation practices or
other malpractices. In addition, derivatives can be used to evade tax law and
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 33
accountancy standards by manipulating the exact flows of payments in reporting
earnings
61
.
1.2.5 Hedging
Hedging is investing in a particular way in order to reduce the risk of adverse price
movements in a security or asset. Hedging has been praised for helping companies avoid
unexpected financial shocks.
Hedge funds
Hedge funds are funds operated by an investment company, which use very speculative
strategies to obtain the highest possible return on their investments. They invest in all
kinds of very sophisticated financial assets, and then sell parts of this portfolio to investors
by issuing shares, much like any other company sells shares to the public. In practice,
hedge funds are thus only accessible for wealthy individuals and institutional investors, in
contrast to so called mutual funds who are accessible to regular households as well.
There is no formal definition of hedge funds, and between the thousands of hedge funds
that exist today, there are important differences. However, some general characteristics of
hedge funds can be identified
62
:
Hedge funds get their name from the first hedge funds’ strategy to hold some
securities for a long-term period, and sell other securities after a very short time.
This combination is supposed to “hedge” the fund from risks associated with
changes in market prices.
Hedge funds use sophisticated strategies to increase the returns on their
investments. They invest in all kinds of financial assets like bonds, shares and
foreign currencies. In addition, they make extensive use of derivatives, financial
instruments whose value is based on the performance of other (financial) assets
(e.g. futures and options). Many hedge funds make these investments with
borrowed money. By using derivatives and borrowed money, hedge funds are
highly “leveraged”. This means that they finance their operations more by debt
than by money they actually own.
They apply extremely high minimum investment requirements. Most hedge funds
set extremely high minimum investment amounts, ranging from $250,000 to over
$1 million. In 2003 the mean minimum investment requirements of global hedge
funds were $630,414
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.
Customers of hedge funds pay the management a fee based on the assets they
have put into the fund (around 1-2%). In addition, they pay the management a fee
based on the performance of the fund (around 20%). Fund managers normally
also make significant investments in the fund. Often, hedge funds also invest in
other hedge funds to increase potential returns (“fund of hedge funds”).
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 34
Trends and Critical issues
Industry has grown enormously
Hedge funds have grown enormously since their rise in the 1950s. Increasingly,
not only wealthy individuals but also institutional investors like pension funds have
invested in hedge funds or less speculative hedge instruments offered by financial
firms in search of better returns than those from traditional mutual funds. In 1994,
total US hedge funds assets were US $ 99 billion, ten years later this was US $
795 billion.
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Risky strategies
Hedge often take large risks on speculative strategies, including in markets with
sharply declining prices. Because they move billions of dollars in and out of
markets quickly, they can win enormous amounts, but of course they might also
loose them. If they loose money, they often loose the money of banks they borrow
from. The most notorious example of this was the 1998 failure of the US based
‘Long Term Capital Management’ (LTCM) fund. To avoid a systemic financial
crisis, the US central bank intervened, injected billions of dollars in the fund and
took over its management.
Hardly any regulation
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Hedge funds are exempt from many of the rules and regulations governing
regular investment funds. They are often managed in the US or another European
country, but ‘domiciled’ in offshore centres, i.e. small countries and islands where
there are no regulations in place, and no taxes to be paid. Important offshore
centres for hedge funds are the Bermuda, Caribbean and the Canal Island
Guernsey. Hedge funds are in practice thus not required to publish data on their
trading activities and their creditworthiness like any other financial institution.
After the notorious LTCM collapse, international bodies like the IMF, the Basle
Committee and the Financial Stability Forum, increasingly started to discuss
possible regulations. More recently, the SEC (the US Securities and Exchange
Committee) has been discussing more concrete regulation proposals.
No sustainability indicators
Hedge funds do not pay any attention whatsoever to the social and environmental
impacts of their investments.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 35
Hedge funds, some controversies
Hedge funds are important speculators on financial markets. Speculation means that an
investor trying to make profits by gambling on changes in the price of a security. When he buys
an asset, a speculator thus doesn’t intent to keep it, he just buys it in order to sell it at a higher
price in the near future. Examples include currency speculation: an investor (or fund) expects
the value of a certain currency (say the Euro) to increase in a month time, and therefore buys
huge amounts of euros. When indeed that price has risen, he can sell the euros at a higher
price.
Because of the enormous amount of funds they manage, hedge funds often also aim to
influence prices by using their market power. Hedge funds can coordinate their actions, and
persuade other market actors to follow them.
Market manipulation is an illegal activity hedge funds have sometimes found guilty of. It means
that they try to influence the prices by spreading misleading information that will probably affect
other investor’s demand for a security. This change in price can lead to enormous profits for the
funds.
Adverse impact on local economies
Hedge fund’s impact on local economies can be enormous. For example, if hedge fund
managers expect a currency to depreciate, they can start to sell their holdings of the currency
in question. Often, other market participants follow the funds with high reputation, and this
further drives down the prices of the currencies. Central banks are often not able to counteract
these speculative forces. Because their gigantic size, and their influence on other market
actors, hedge funds can make or break currencies. A notorious example of this was the attack
of the hedge fund manager George Soros on the English pound in 1992. By speculating on a
depreciation of the currency, the fund forced the British currency out of the European system of
fixed exchange rates. Other examples include the speculative attack on the Thai Baht and
other South Asian currencies 1997, which led to dramatic aggravation of the Asian crisis.
Frauds at hedge funds
Hedge funds have sometimes been blamed of manipulating market prices, which
disadvantages smaller investors. For example, they make other investors believe a company is
doing very well, and this will make the price rise. After this, hedge funds sell their holdings of
these securities and make a huge profit. Retail investors are duped by this, since they only see
the value of their holdings plunge. There also have been cases of funds misleading their own
investors.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 36
1.2.6 Asset management
Asset Management (also called money management, investment management) is simply
the process of managing all kinds of investments, budgeting, financing and taxes. An
important part of asset management takes lace at pension funds, mutual funds and
insurance companies, as described below.
Financial firms earn fees by providing services (investment advice, investing funds,
derivatives) to corporations, wealthy individuals and institutional investors regarding the
management of their capital and other assets. Their job is also to insure their clients get
the highest rate of return.
1.2.7 Pension funds
Pension provision is organised in different ways. Sometimes retirement benefits are paid
from contributions of current employees (so-called pay-as-you-go financing).
In other systems, mainly in the US, and European countries like the UK and the
Netherlands, funded schemes are more common, in which contributions are accumulated
in a fund until the person retires. A pension fund can be set up by a company,
governmental institution or labour union. The management first collects pension benefits
from workers and their employers, and invest this money in all kind of assets. Because the
funds have collected money of up to millions of individuals, they are major players on
financial markets.
The fund managers make actuarial assumptions about how much they will be required to
pay out to pensioners and then try to ensure that the rate of return on their portfolio
investments equals or exceeds that anticipated pay-out need. Pension funds or pension
insurance companies often delegate the actual investments to financial firms such as
investment houses or banks
Trends & Critical issues
Dominant players on the market
Pension funds buy all kind of securities on the international markets. Their
purchase of shares has helped create a bubble of high share prices partially
because the pension funds have hundreds of billions of dollars to invest. Once the
stock market starts to fall, the pension funds try to reorganize their portfolios,
which contributes to the rapid decrease in share values (since they move so
much money at once).
Losses due to stock market decline
In countries such as the UK or the Netherlands, regulators do not restrict pension
funds from investing heavily in the equity market (unlike in Germany). This means
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 37
that large portions of Dutch and British pensions are invested in listed, both
domestic and foreign, companies. With the fall of stock markets, pension funds
have lost billions of dollars and Euros in the last few years and now many cannot
guarantee that they will pay out 100% of the promised pensions to their
contributors in the future. Pension fund supervisory authorities have had to
intervene to force pension funds to come up with strategies to ensure all future
payment obligations. Consequently, pension funds have been switching to the
bond market, which is a more secure source of income for their long-term
obligations.
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Additional income for pension funds generated by increasing the
contributions made both by employees and employers is decreasing workers
income and companies profits. Some pension funds however are restructuring
and merging while another strategy has been to turn to hedge funds and
corporate bonds, which could bring higher yields but which have also a high risk
of failure.
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Little attention to ethical indicators
Pension funds have traditionally cared little about investing in securities of
companies that are considered ethical or environmental, i.e. have a positive effect
on the environment or that respect labour rights and human rights (see chapter
4). In the Netherlands, for example, only 1% of pension funds’ money is estimated
to be directed to sustainable investments.
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1.2.8 Mutual funds
Mutual funds are funds operated by a bank or an investment company that invest their
money in a group of assets, including shares in various companies, bonds, options,
futures, currencies, or money market securities in accordance to a stated set of objectives.
They then sell parts of this portfolio to investors- households but also institutional investors
- by issuing shares much like any other company sells shares to the public. A mutual fund
can be more attractive to investors than individually composing a portfolio of assets. This
is the case since their money is managed by professional asset managers, and their
portfolio is very diversified to reduce risks. A management fee is charged for these
services. All shareholders share equally in the gains and losses generated by the fund.
Trends
Booming business…
Banks and investment funds have created a variety of mutual funds that invest in
specific countries or sectors. The increasing prices of the stock market had
attracted a lot of individual and institutional investors to buy units of mutual funds,
providing banks and mutual funds with high income from the management fees.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 38
Losses after the stock market bubble
Lower stock prices in 2002-2003 decreased the value of mutual funds
substantially. In some cases investors have lost up to 50% of the value of their
units. Some mutual funds and banks providing those services lost a significant
source of income, which resulted in some mutual funds closing down completely.
In 2003-2004 the mutual fund industry started to grow again. As of December
2003, the mutual fund business in the US was valued at US$ 7,000 bn and 8,000
bn beginning April 2004.
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Scandals at mutual funds
70
The following practices are calculated to have cost the individual US investors (95% of the
population) $ 10 bn:
Late trading and market timing: transactions after 16 hours, the official closure of trading mutual
fund shares, which allows advantages to be taken by price differences between old share
prices and new prices of the next day, or between different international stock exchanges in
different time zones.
Rapid trading and market timing: mutual funds have allowed big investors, mainly hedge funds,
to rapidly trade of shares of international mutual funds in a way that takes advantage of
discrepancies in asset values across time zones. This siphons off profits at the expense of
long-term investors. Although these practices are not necessarily illegal, 22 US mutual funds
have been investigated by the US Securities and Exchange Commission in 2003 and have
changed staff. The highest fine had to be paid by Alliance Capital, $ 250 million. Bank of
America is also under investigation.
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Individual fund managers have also been sentenced.
Just one fund manager was able to make a profit of $ 600,000.
Improper sales practices: Morgan Stanley had to pay a $ 2m fine for improper incentives (such
as exotic travel trips and tickets for Rolling Stone concerts) to its sales staff to push their own
mutual funds to clients over other mutual fund products (non proprietary funds).
Too high fees: the costs for managing mutual funds were untransparent and mutual fund
charged clients too much for it.
As a result of the malpractices in the US, the European securities supervisor (CESR)
conducted a survey on the situation at European mutual funds. They didn’t find major
malpractices, however, the report concluded there were “issues of regulatory concern”. For
example, fund managers said they were sometimes approached by investors to allow market
timing and late trading, and in the absence of clear procedures and responsibilities, the
existence of those practices could not be excluded
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.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 39
Critical issues
Destabilising impact on local economies
Because of their size, like hedge funds, mutual funds’ investment decisions have
an enormous impact on local economies. In the mid 1990s, mutual funds bought
heavily into securities of emerging markets. This dramatically affected the upturns
and downfalls of those economies. It is the quest for short-term gain or quick
profit which motivates funds and traders to buy and sell quickly, regardless of the
impact on the societies in countries in which they invest and the long-term
benefits which are lost.
For example, the appetite for investments in emerging market countries (EMCs),
was dramatically curtailed by the Asian Crisis of 1997, the Russian default and
subsequent near financial meltdown of 1998, the resulting problems in Brazil and
elsewhere, and the collapse of the Argentine economy (2001-2003). When mutual
funds and traders in securities quickly withdrew securities from countries in
financial crisis, their actions further decreased the value of all securities. This was
the case in South East Asia, and this helped exacerbating the overall financial
crisis.
The lack of transparency in pricing (see box)
The lack of transparency and clarity between the cost of to manage the fund and
the management fee charged to clients has lead to various pricing scandals.
Fund managers are also increasingly under investigation for not abiding by
trading rules including trading after the cut-off time (late trading). These scandals
have lead to lawsuits and indictments because of overcharging, which have made
some mutual funds more accountable to investors.
Growth of ‘ethical investments’
So-called green funds and ethical funds are popping up all over the place.
Mainstream mutual funds are also increasingly offering these ethical investment
options. This growth highlights an increased attention of investors for sustainable
development. Growth of these investments can also be facilitated by government
regulations. For example,
in the Netherlands,
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investors are exempt from interest and dividend income tax
coming from green funds that fulfil environmental criteria laid down by the
government. The tax exemption is intended to compensate the lower interest
rates and dividends of those green shares, and the system seems to work fairly
well. In fact, Dutch green funds, worth around a billion Euros, have been so
popular that there have not been enough green projects to finance. Investors
have to queue-up before joining the green fund, which indicates that citizens do
invest in green funds if they have the choice, and that a tax incentive can create a
strong demand for such funds.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 40
But … lack of clear indicators
Marketing ethical investments is a ‘growing trend’ as the general public learns
more about the connections between the stock market, pension funds and other
investments. However, clear, widely adopted standards or green funds and ethical
funds do not exist. Therefore green fund managers, and governments in some
cases, are setting their own terms of reference. Most mutual funds managers
continue to focus only on the bottom line, or the company’s financial and
economic performance rather than its contribution to environmental sustainability
or commitment to human rights. Civil society groups thus continue to be critical of
many ‘so called’ ethical or green investment assessments.. (For further analysis,
see chapter 4)
1.2.9 Trust services
Banks can provide trustee services and services for the formation and management of
companies that are either special purpose companies, holding, trading, finance or royalty
companies belonging to an international group, or privately owned offshore companies.
Normally the shareholders, management and statutory seats of such companies are
spread over, at least, two countries.
Trustee services include services necessary to fulfil all legal and other requirements to
keep a company in good standing however, most of these companies, which are provided
by banks, are created to evade tax. They are mostly "post box companies" in countries
with relaxed tax regimes and little investigative supervision or regulation.
Critical issues
Trustee services are invisible but have major impacts
Bechtel:
Bechtel formed a consortium that was officially based in the Netherlands. In
reality the consortium was just a "post box company" managed by ING Group's
Trust services in the Netherlands. This consortium bought the privatized water
services of Cochabamba in Bolivia. Following the intense civil unrest and protests
due to the rising water prices privatization was reversed. The consortium tried to
win compensation through the investment protection provisions of the bilateral
investment agreement between Bolivia and the Netherlands.
Parmalat:
Trustee services are often seen as purely administrative support for a ‘staff-less’
company (i.e. postal address only). However in the case of the scandalous
Parmalat (Italian milk and food conglomerate) the trust units were both in off
shore centres and in the Netherlands. Those companies in the Netherlands were
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 41
responsible for issuing billions of Euros in bonds, which, now we know, will not be
repaid. The Parmalat trustee service responsibilities proved difficult to clarify.
1.3 Rating services
A rating agency is a company that is specialized in evaluating the capacity to repay debt
(“creditworthiness”) of companies and governments. Most often they give ratings to debt
instruments like corporate and sovereign bonds, but it can also concern commercial loans.
The rating is expressed by a code, ranging from AAA as the highest creditworthiness, and
C or D as the lowest. Rating agencies earn their money by charging a fee to the
companies and governments they rate, and by selling their findings to the public.
Currently, there are over a hundred credit rating agencies operating worldwide. However,
in practice, three of them dominate the market: Standard’s & Poor, Moody’s and Fitch
Ratings. All three of them are based in the US.
Currently, investors often don’t even accept bonds from companies and governmental
institutions that don’t have a rating from one or more of the major rating agencies.
Companies and governments who wish to borrow on capital markets thus are completely
dependent on private firms who will rate their creditworthiness. Given this dependence on
having a rating, borrowers are willing to pay substantive amounts of money for this. For
borrowers, the fees for obtaining a rating can be over a million US dollars.
Trends and Critical issues
Increasing power
The role of rating agencies has increased especially since corporate and
sovereign bonds got more common. With borrowers heavy reliance on their
ratings, many companies and governments are very concerned about the
judgements of ratings agencies. A change in ratings can make or break investors’
confidence, and will enormously raise borrowing costs. Some institutions’ financial
portfolio is directly dependant on ratings of the big rating firms. For example,
pension funds are often only allowed to hold bonds rated at investment grade,
which is not below Baa/BBB (see box). A lowering in rating can thus have an
enormous effect if institutions like pension funds have to sell those assets. In the
future, the power of rating agencies will only increase when a new international
regulatory framework for banks will be in place (“Basel II”). According to the Basel
II framework, banks can use ratings of private rating firms’ or public institutions
like ECA’s to determine how risky loans will be, and thus how much interest
borrowers will have to pay. (see chapter 5)
Conflict of interests
Private rating agencies get paid to give a company or state a rating. Rating
agencies stress that it is in their own interest to remain completely independent,
since their sound reputation is key in attracting business. However, in the
absence of many competitors, conflicts of interests may still arise.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 42
Failure to adequately rate borrowers
Rating agencies have often proved not to be able to anticipate decreasing or
improving creditworthiness of borrowers. A major example was the collapse of
companies like Enron and Parmalat. According to rating agencies just prior to
those companies’ collapse, bonds of those companies didn’t contain much risk of
default. Only after it became public in how bad a financial state the firms were, did
the agencies lower their rating. For example, Standard & Poor, one of the major
rating agencies, continued to give Parmalat a high rating until December 2003,
despite the fact that the 10 billion Euro fraud was becoming public knowledge.
The same happened during the Asian crisis. Prior to the crisis, ratings were at
reasonable levels. When the crisis erupted, rating agencies dramatically lowered
the ratings of the countries concerned, which according to many further
aggravated the crisis because more investors immediately pulled out of the
region. In case of South East Asia, the financial crisis could possibly have been
mitigated if rating agencies warned creditors and the foreign banks of the
approaching lack of capacity to make repayments in foreign currencies.
No sustainability indicators
To date, rating agencies do not include any information about a company’s
environmental and social behaviour in their rating assessments. There exist
specific rating agencies that aim to take these social and environmental issues
into account, and give a company a rating on this basis (such as SiRi company,
see chapter 4). However, they rate all kinds of companies on sustainability
grounds, but do not combine this with an assessment of their capacity to repay
debts. Thus, they will not have a substantive impact on creditors looking for
information on creditworthiness.
1.4 Insurance services
Insurance is a promise of compensation for specific potential future, unexpected losses in
exchange for a periodic payment.
Agreeing to the terms of an insurance policy creates a contract between the insured and
the insurer. In exchange for payments from the insured (called premiums), the insurer
agrees to pay the policyholder a sum of money upon the occurrence of a specific event. In
most cases, the policyholder pays part of the loss (called the deductible), and the insurer
pays the rest. Examples include car insurance, health insurance, disability insurance, life
insurance, and business insurance.
Premiums are determined on the probability of risk as well as competition with other
insurers. Generally, insurance spreads out the risk (of potential claims from individuals
and companies) to a larger group whose sums are better able to pay for losses.
Insurance policies are often sold to individuals and companies through insurance agents
who are licensed representatives of one or more insurance company, or through
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 43
independent insurance brokers who search for the lowest cost for the client by comparing
competing insurance companies.
Forms of insurance to individuals include:
Personal property insurance: Such as automobiles, homes; the insurance policy
specifies which property, accidents and casualty perils, theft and other damages
are covered.
Life insurance: Guarantees payment to the beneficiaries when the insured person
dies. The insurance policy spells out whose life is insured and which beneficiaries
will receive the insurance proceeds.
Health insurance: The policy specifies which medical treatments and drugs are
reimbursed.
Insurance services to corporations protects against:
Liability: e.g. of board members, environmental damage
Property damage to, and loss of e.g. computers, transported goods
Losses that endanger the continuity of the company’s activities: e.g. of computer
data
Fraud and other financial problems
Extra payments for employees: e.g. for long term illness, accidents, absenteeism,
pensions, unfair dismissal, sexual harassment, discrimination
Transport
Blackmailing
Reinsurance is the sharing of insurance policies among multiple insurers and selling
securities on the market. Reinsurance companies (e.g. the German Munich-Re) are
specialized in insuring the insurance industry.
Export credit insurance
A special form of insurance is the insurance of export payments. All industrialized
countries have one or more export credit agencies (ECA) that will pay for potentially
missed export earnings. In recent years, many of those agencies have been privatized.
If a company is exporting to another country, and will receive the money only after the
export has been finalized, it can request an export credit at a commercial bank. If the bank
is not sure whether it will receive the payments for the goods exported to the country in
question (e.g. when it concerns poor countries), the bank can get an insurance against
this risk.
Trends & Critical issues
Disappearing reserves
The European insurance sectors are facing the same problems as the pension
funds, namely lack of funds. European insurance companies invested heavily in
the equities and derivatives markets but with the economic downturn over the last
few years, insurance companies lost a significant portion of their assets, which
has affected their ability to pay out for claims (see also chapter 2).
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 44
The situation is so critical that governments concerned about the solvency of
insurance companies (one Germany insurer already went bankrupt) are
increasing supervision and tightening regulatory systems, which is a sign that
even big European private insurance companies take too many risks and need
more regulation and supervision.
Insurance companies are still vulnerable especially if the stock market and the
economy continue to weaken.
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Action on climate change
Increased claims for environmental damages due to erratic weather, has meant
that some insurance companies have begun specializing in climate change
related damages. They have an important analysis and databank capacity on
climate change phenomena. Some (e.g. re-insurer Munich-Re) educate others in
the financial industry about the importance of quelling climate change.
Targeting the rich in developing countries
Western insurance companies enter developing countries and sell private health
insurance products to those who can afford the policies, in many cases leaving
the government and domestic private insurance companies burdened with the
poor patients. The question remains if the presence of Western insurers in poor
countries help increase general access to health insurance?
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Equity funding
Equity funding is an investment, which combines a life insurance policy with
shares in a mutual fund. The fund shares are used as collateral for a loan to pay
the insurance premium, giving the investor the advantages of insurance
protection and investment appreciation potential. These advantages disappear if
the value of the mutual fund does not increase.
Scandals in the insurance industry
In 2004, investigations of the New York attorney-general Eliot Spitzer revealed
some major scandals at US insurance companies and brokers. These brokers are
the intermediaries between buyers and sellers of insurance products and make
money by charging both parties a commission. It became apparent many US
insurance brokers and insurance companies were collectively betraying
customers by charging too high premiums. Insurance firms offered brokers so-
called “contingency-commissions” – commissions that are only paid if the broker
delivers a certain amount of clients to the company. This has lead to many
manipulations, as brokers have eagerly accepted these offers, and have
sometimes even threatened to destroy an insurance company if they didn’t get
extra commissions.
Among the companies found guilty was Marsh & McLennan, the biggest
insurance broker worldwide. In 2003, income out of contingent commissions
accounted for $ 845 million of the groups turnover. Since the end of 2004, the
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 45
company has had to change its business model and doesn’t accept the
contingency commissions anymore
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.
The world’s biggest insurance company, American International Group (AIG), has
also been under heavy investigation. It became apparent that there had been
many irregularities in the company’s financial reporting. The chief executor,
Maurice Greenberg, already had to resign. In addition to these reporting
practices, AIG has also been accused of market manipulation. Just prior to AIG’s
takeover of American General in 2001, Greenberg is said to have pressured
traders of the New York Stock Exchange to buy AIG shares in order to boost the
stock price.
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Private risks turned into developing countries’ debt
78
When a developing country importer fails to pay for its imports, the exporting firm
or bank who provided an export credit, will be compensated by the ECA
concerned, minus a small percentage of own risk. In case the ECA also fails to
get this money back, they will simply add this amount to the developing countries’
official foreign debt. In this way, private risks are being transferred to developing
countries’ and of course, eventually its taxpayers.
The share of ECA debt of total official debt is enormous; in 2002 it is estimated to
account for 34 % of total external official debt to aid receiving countries ($
368,503 million of $ 1,064,718 million). Sometimes, ECA debts are even based on
controversial exports such as weaponry. In this case, industrial countries’ exports
of weapons to developing countries have to be paid for by the importing country
(and eventually its taxpayers, who have often been the victim of the use of these
weapons).
Many civil groups have been pressing for reforms of ECA’s, and for debt relief of
the ECA debt. Aid organizations point out that it is crucial that this debt relief that
Western governments do not deduct the ECA debt relief from the official
development aid (ODA) budget, as is often the case in many industrialized
countries. They state that cancellation of debt that arose from private sector risk
should never reduce the budget for true development aid.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 46
1.5 Conclusions from the perspective of poverty
eradication and sustainable development
1. Financial services focus on big companies and the rich
Most "products" of the financial services' firms service large companies and investors, not
individuals and governments. A key strategy at banks is to target their services at the most
profitable clients or institutional investors and companies, leaving the less wealthy at a
severe disadvantage. At the same time, they create huge debts by companies and
individuals.
In some countries, ‘market segmentation’ has resulted in the closing of branches and the
exclusion of poor clients through a reduction of basic services and the compulsory use of
computerized transaction services. Small and medium enterprises, which are vital to the
economy, are treated less favourably than those big corporations that are offered better
interest rates.
That banks are driven by profit and increasing pressure from international competition,
means that poorer clients could require more legal protection against limited and poor
quality service. Market forces will not ‘naturally’ help poor clients when they are at such a
structural disadvantage.
2. Governments are clients of the financial industry
The financial industry is heavily involved in government debt through loans, syndicated
project lending, debt derivates, trading in debt and underwriting and trading in government
bonds.
The funds for conditional lending to developing countries by the World Bank come largely
from bonds underwritten and traded by investment banks. Financial firms often jointly fund
projects supported by the World Bank. This dependence of financing by private financial
firms might challenge the regulatory independence of governments, especially in
developing countries.
3. Manipulating financial markets
The financial industry played a significant role in creating the stock market bubble, which
slowly crashed from 2001 to 2003. The industry was instrumental in increasing stock value
through services such as:
investment banking (new shares on the stock market),
analysis, research and advisory services for those investing in the stock market,
including pension funds,
trading and brokerage in securities, including derivatives and share lending,
mutual funds for both small and large investors, making investment in equities
more accessible,
selling hybrid financial products in which, for instance, loans and insurance were
combined with investments in equities.
In addition, financial firms were manipulating share prices by releasing wrong advise to
benefit companies that were or could become their clients. The seriousness of the fraud is
evident from the US$ 1.4 bn fine by the Securities and Exchange Commission to large US
banks. Some mutual funds also over charged clients and traded illegally.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 47
In bond markets, market manipulation is also not unusual, as the Citigroup scandal
highlights (see box 1.2.1 ‘scandals at financial firms’).
The heaviest burden of the fall-out from the artificially high value of the financial market
has been on individual investors (including pensioners), pension funds, insurance
companies, and companies from the developing countries.
4. The efficiency of the financial industry far from accomplished
Some major failures of the financial industry disclosed over the last decade are:
Concentration at European banks: A recent study showed that European banks
are not very well diversifying their portfolio to reduce risks. They often have a
small number of big clients they concentrate their activities on, and in case of a
default, this could easily endanger a bank’s financial position
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.
Some pension funds invested heavily in the stock market and with the crash,
cannot now guarantee fully delivering peoples’ pensions. Should pensions in
developing countries be privatized and subject purely to unstable market forces?
Financial reserves in the European insurance industry have been reduced to
dangerously low levels due to over-investment in the stock market and far-
reaching crises including, environmental disasters, terrorist attacks and corporate
scandals.
Rating agencies often failed to provide warnings on financial problems at
governments and companies. Artificially inflated ratings encouraged the financial
industry to continue investment in governments and companies with dubious
financial state of affairs.
When mutual funds and traders in securities quickly withdrew securities from
countries in financial crisis, as was the case in South East Asia, their actions
further decreased the value of all securities thus exacerbating the overall financial
crisis. It is the quest for short-term gain or quick profit which motivates funds and
traders to buy and sell quickly, regardless of the impact on the societies in
countries in which they invest and the long-term benefits which are lost.
Investment banks increasingly underwrite bonds from loss-making companies
and many small investors are loosing their money. The investigation of the role of
large banks in the hiding of Parmalat's debt of more than Euro 12 bn, is a clear
example.
5. Unknown effects of little known financial services
The financial industry is trading in and designing new and more complex financial
products, which are less and less transparent and difficult to monitor. Increasingly, the
risks involved with these speculative services are becoming more unpredictable for both
the consumer and the authorities.
For example, the increased popularity of credit derivatives, which transfer banks’ lending
risks to speculators and institutional investors, including insurance companies, is a trend
closely monitored by the authorities. Passing off or selling risk, particularly with credit
derivatives, is potentially the basis for financial crisis, which should be a concern for civil
society and the authorities.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 48
1
Except otherwise indicated, the explanation of the financial terminology in this chapter is based on, or
taken from: J. Downes, J. Elliot Goodman, Dictionary of finance and investment terms, (Barron's
Financial Guides), Sixth Edition, 2003; R. Lister, L. van der Deijl, A handbook of commercial and
economic terms, English-Dutch, (Intertaal), 2001.
2
Deloitte & Touche Research, How to Make Customer Loyalty Real, 1999.
3
See for instance J.P. Morte, Consumer Banking, in Business World (Philippines), 7 July 2003
4
T. LoFrumento, How profitable are your customers?, 2003 Bell & Howell Information and Learning,
April 2003, p. 24-31.
5
Erica Verdegaal, Winkels, consumenten en banken kunnen niet zonder elkaar. Knelpunten en
oplossingen bankdiensten in kaart gebracht, in DNB Magazine, De Nederlandsche Bank, no. 1, 2005
6
Makeover and make money, in The banker, 2 December 2003.
7
CELENT, Cross-selling in European retail banking: strategic lessons for incumbents, press release,
Paris, 27 August 2001.
8
In Belgium at least 40.000 of those living on minimum wage have problems accessing basic financial
services according to: Banken zouden in Belgie 40 000 personen uitsluiten: een enquete, in S.E.E.
Newsletter - Social & Environmental Efficiency, nr. 23, 26 December 2001.
9
UvA-student wint national scriptieprijs, in Folia 21, 56th year, 31 January 2003, p.6.
10
J. Slagter, Ook klanten van banken moeten iets te kiezen hebben, in Het Financieele Dagblad, 4
December 2001.
11
Mass panic grips Zimbabwe banks, 15 January 2004, at http://news.bbc.co.uk/go/pr/fr/-
/2/hi/africa/3400369.stm
12
J. Authers, Mexicans send more than $ 1 bn back home in July, in FT, 19 September 2003.
13
N. Instefjord, Risk and hedging: do credit derivatives increase bank risk?, at
http://www.econ.bbk.ac.uk/faculty/instefjord.html, p. 5.
14
BIS, Sovereign credit default swaps, in BIS Quarterly Review, December 2003, p. 79.
15
For more information see: www.credit-deriv.com
16
The definition is a simplified version from I. Marsh, What banks can learn about default risk from credit
markets, in Market functioning and Central Bank Policy, BIS Papers nr. 12, August 2002, p. 330; and
N. Insterjord, Risk and hedging: do credit derivatives increase bank risk? At
http://www.econ.bbk.ac.uk/faculty/instefjord.html, p. 4; J. Kiff and R. Morrow, Credit derivatives, in Bank
of Canada review, Autumn 2000, p. 4.
17
For a detailed survey on credit risk transfer and its potential risks, see The Economist, How is carrying
the can?, Special Report: Bank Lending, August 16
th
2003
18
BBC World Service, 13 January 2004.
19
Ethnic minority business in the UK: Access to finance and business support - A report by the British
Bankers Association, quoted in Marketing International, 22 January 2003, p. 10.
20
www.socialfunds.com/news/article.cgi/article1073.html: the report America's best and worst lenders: a
consumers' guide to lending in 25 metropolitan areas covering 2000 and 2001is made to reinforce the
US Community Reinvestment act which is often not respected.
21
S. Jung-a, A. Ward, Plan to ease rules sparks warning, in FT, 30 September 2003.
22
Financial Times, articles in December 2003 and January 2004.
23
Visakaart als hebbeding, in NRC Handelsblad, 28 August 2003.
24
See J. Kiff and R. Morrow, Credit derivatives, in Bank of Canada Review, Autumn 2000, p. 8-10.
25
N. Instefjord, Risk and hedging: do credit derivatives increase bank risk?, at
http://www.econ.bbk.ac.uk/faculty/instefjord.html, p. 0.
26
Financial Stability Forum, Statement by Roger W. Furgerson, JR., Chairman of the Financial Stability
Forum, International Monetary and Financial Meeting, 21 September 2003.
27
The Economist, How is carrying the can?, Special Report: Bank Lending, August 16
th
2003
28
I. Marsh, What banks can learn about default risk from credit markets, in Market functioning and
Central Bank Policy, BIS Papers nr. 12, August 2002, p. 338.
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 49
29
See for instance: A. Hoog, Nallie Bosman: CEO, ABSA Bank, in Moneyweb (South Africa), 2 June
2003.
30
J. Slagter, ABN Amro trekt Braziliaanse sloppenwijken in, in Het Financieele Dagblad, 9 October 2003.
31
Peter Thal Larsen and David Wighton Investment banking 2005. Record earnings as sector recovers,
in FT January 27 2005
32
Under the regulatory yoke, in FTfm, 19 January 2003, p. 28.
33
J. Wiggins, Low interest rates help lift performance, in FT, 8 December 2003.
34
The Economist, Love is in the air, February 5
th
2005
35
E. Backus , F. Kapner, Parmalat plaintiffs put hopes in US justice, in FT 11 March 2004
36
J. fuller, No one attempted Parmalat jigsaw, in FTfm, 19 January 2004, p. 6.
37
F. Kapner e.a., BofA offices raided in hunt for Parmalat's missing billions, in FT, 10-11 January 2004.
38
Information from Andrea Baranes (Campagna per la reforma della Banca Mondiale, Italy)
39
Ook Citigroup schrijft fors af op leningen aan Parmalat, in Het Financieele Dagblad, 21 January 2004.
40
FT, Parmalat prosecutors ready to request charges, February 14
th
2005.
41
See for more info on the WorldBank bonds boycott, http://econjustice.net/wbbb/
42
Citicorp 4th-qrt profit rises 96% to 4.76 billion (update 3), Bloomberg.com, 20 January 2004
43
See box: Scandals at financial firms
44
G. Hettinga, Zakenbanken op strafbank, in Effect, 2003, nr. 1; Bloomberg, Citigroup, Morgan Stanley
CEOs risk SEC penalties, 06/04/03
45
BIS, 73rd Annual Report, p.102-103.
46
Citigroup, Joint Statement by Tom Maheras, CEO, Global Capital Markets and William Mills, CEO,
Europe, Middle East, & Africa, Citigroup Corporate and Investment Banking Group, Citigroup Press
release, February 02, 2005, through ww.citigroup.com
47
Païvi Munter and Charles Batchelor, Citigroup cleared of bond market offence, in FT, 22 March 2005
48
A. Michaels, D. Wells, JP Morgan in $ 24m settlement, in FT, 2 October 2003
49
A. Michaels, SEC slaps $ 10 m penalty on Bank of America, in FT, 11 March 2004; D. Wells, Bank falls
foul of family favourites, in FT, 5 March 2004.
50
S. Donnan, Jakarta set to appoint banks for bond issues, in FT, 19 January 2004.
51
This section is based on The Economist, Private equity, Size matters, January 29
th
2005 ; Paul
O’Keefe, The Rise of the new conglomerates, BBC Radio, In Business, February 10
th
21.30, online at
http://news.bbc.co.uk/1/hi/business/4249673.stm
52
The Economist, Private equity, Size matters, January 29
th
2005
53
Paul O’Keefe, The Rise of the new conglomerates, BBC Radio, In Business, February 10
th
21.30,
online at http://news.bbc.co.uk/1/hi/business/4249673.stm
54
See Stijns Claessens, Thomas Glaessner, Daniele Klingebiel, Electronic Finance: Reshaping the
Financial Landscape around the World, Table 2, Worldbank Financial Sector Discussion paper no. 4,
September 2000
55
NRC Handelsblad, Vd Moolen wil toezicht op beurzen, February 24th 2005.
56
See FT, UK City watchdog warns over foreign takeover of London Stock Exchange, 5 February 2005
57
M. Vander Stichele, Is de financiële crisis voorbij?, SOMO (Amsterdam),1999, p. 20-21.
58
Mark Houben & Menno Tamminga, “Leaseaffaire breekt alle records”, in NRC Handelsblad, 11
February 2005; NRC Handelsblad, “Leaseschadefonds int 425 mln extra”, 11 February 2005
59
F. Gimbel, Investors ignore risky practices, in FTfm, 1 September 2003, p. 1.
60
Randall Dodd, Derivatives Markets: Sources of Vulnerability in U.S. Financial Markets, Derivatives
Study Center, at www.financialpolicy.org
61
Randall Dodd, Derivatives Markets: Sources of Vulnerability in U.S. Financial Markets, Derivatives
Study Center, at www.financialpolicy.org
62
Based on information from the Derivatives Study Center, (www.financial policy.org; Barry Eichengreen,
“Governing Global Financial Markets: International Responses to the Hedge-Fund Problem,” in Miles
Kahler and David A. Lake Governance in a global economy, Princeton University Press, 2003
63
Kyle L Brandon, The state of hedge funds:2004, SIA research reports, 20 September 2004, at
www.sia.com
Critical Issues in the Financial Industry
Chapter 1 - Financial Services 50
64
Kyle L Brandon, The state of hedge funds:2004, SIA research reports, 20 September 2004, at
www.sia.com
65
J. Chaffin, SEC report proposes hedge fund registration, in FT, 30 September 2003.
66
P. Davis, UK Charity funds gain by sticking to equities, in FTfm, 19 January 2004, p. 2
67
Under the regulatory yoke, FTfm, 19 January 2004, p. 28
68
Christel Witteveen, Groot geheim. Het beleggingsbeleid van pensioenfondsen, in People, Planet Profit,
Volume 3, no 2, Winter 2004/5
69
D. Brewster, Market timing double blow for Alliance, in FT, 19 December 2003; D. Brewster, Janus puts
executive on indefinite leave, in FT, 6 April 2004.
70
D. Brewster, Prudential oust 12 brokers over watchdog probe, in FT, 2 October 2003; E. Kelleher, SEC
set to charge MFS, in FT, 9 December 2003; D. Brewster, Market timing double blow for Alliance, in
FT, 19 December 2003; Beleggingsfondsen in de VS sjoemelen op grote schaal, in Het Financieele
Dagblad, 5 November 2003; A. Michaels, D. Wells, Morgan Stanley fined over mutual funds, in FT, 17
September 2003.
71
D. Wells, Bank falls foul of family favourites, in FT, 5 March 2004.
72
The Committee of European Security Regulators, Investigations of mis-practices in the European
Investment Fund Industry. Report of the investigations by CESR’ members, November 2004, at
www.cesr-eu.org
73
G. Dekker, Dat geld(t) voor ontwikkeling - geld voor duurzaamheid, NCDO (Kroniek voor duurzaam
Nederland (8)), [2001], 13-15.
74
Financial Stability Forum, Statement by Roger W. Ferguson, JR., Chairman of the Financial Stability
Forum, International Monetary and Financial Meeting, 21 September 2003
75
see J. Kinuthia, Trading in Healthcare Services in Kenya, are we prepared? Case study on the
implications of committing healthcare services in Kenya under GATS , Consumer Information Network
(Kenya), November 2002; see www.somo.nl
76
Economist, Just how rotten? The insurance scandal,
77
FT, PwC to give adverse opinion on AIG, 3 May 2005 ; FT, AIG's share price is re-examined, 9 May
2005
78
For more information on the controversies of ECA’s, see Both Ends, Export Credit DEBT; briefing
paper. How ECA’s turn private risks of corporations into debt for developing countries, at
www.bothends.org; Trouw, Banken slepen Financiën voor rechter, Ontwikkeling weggecijferd, July 12
th
2004, at www.trouw.nl. For more info, see also: www.eca-watch.org
79
Standard & Poor’s, Concentration Risks Remain High at European Banks, October 22th 2004
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 51
Chapter 2
Insights in the financial industry:
trends and strategies
Introduction
The financial services described in the first chapter are provided by the private financial
industry. Most of these financial firms do not provide the whole range of financial services.
Although all banks and insurance companies have started to operate at national levels,
some of them are now important players at the international level. Some financial
conglomerates are established in many different countries, including developing countries.
Others are the main providers, worldwide, of certain financial services and dominate the
international market.
This chapter identifies the major international financial corporations, explains the big
players’ strategies and analyses trends in the international financial services markets.
The analysis intends to provide an insight into the problems these international players
and international financial services markets cause to civil societies and economies,
particularly in developing countries.
2.1 Performance of the financial services industry
a. The financial industry has changed dramatically in the past ten years. Important
shake-ups have affected its performance.
Bigger, faster, more
Bigger financial corporations were formed by mergers and acquisitions or
takeovers (either friendly or hostile).
Faster transactions were created via new technologies and the internet.
More diverse financial products were sold by one single financial conglomerate,
such as insurance and securities.
The changing functioning of financial firms was given a boost with the ratification of the
Gramm-Leach-Billey Act (1999) in the US. The act allowed US banks to expand beyond
their traditional roles of collecting deposits and writing loans
1
and become "allfinanz"
firms as was already possible in European and Asian countries. The liberalisation of
financial services, which allows foreign financial firms to provide services through
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 52
ownership of domestic banks or through trans-border transactions, has also contributed to
the changes (see chapter 6).
Downfall … and upturn in profits
In 2001 and 2002, banks suffered heavy losses from the economic slowdown. Many
financial products, including mortgages and trading in securities, were linked to the value
of the stock market. The economic downturn forced banks to write off billions of dollars in
exposure due to the many real estate and commercial loans that went sour. Bankruptcies
at corporate giants like Enron and WorldCom have also burned large banks such as J.P.
Morgan Chase.
As people put more of their cash into mutual funds and securities rather than deposit
accounts, all banks became increasingly dependent on fee-based services such as
securities trading. In 2001, the top 1000 banks in the world recorded a fall in profits of
30%. However, profits began to recover in 2002 due to the strength of the US banks. Their
growth in 2002 was due to increasing commercial and retail banking services, and
underwriting or trading in governmental and corporate bonds
2
at a time that corporate
lending, investment banking for big business and trading in securities had dropped.
The total pre-tax profit of the top 1000 banks in 2002 was US$ 252.4 bn, which was more
than the GDP of countries like Belgium, Sweden and Austria, and most developing
countries, in the same year. Peak profits had been recorded in 2000 when total
aggregated return on capital reached $ 317 bn.
3
The 210 US banks accounted for 49% of
the profits of the top 1000 banks in the world. In contrast, the 83 German banks only
contributed to 1.1% of the profits of the top 1000 banks. The top 300 European banks had
pre-tax profits $120.2 bn by July 2003.
4
Top banks recorded high profits again in 2003 and the first quarter of 2004, amongst
others from tight expense control, strong retail and commercial banking, diversification of
services and renewed activities in securities.
5
Serious financial problems at European insurance companies
The insurance industry was in very bad shape by 2002, especially in Europe where
billions of Euros were lost (see insurance companies at the end of the table below about
World ranking of the largest financial corporations). It led to a German life insurance
company filing for bankruptcy (Mannheimer Leben) in 2003, which had not happened for
50 years.
6
European insurance companies suffered heavy losses from 2001 onwards for a
combination of reasons, namely:
The steep fall in the value of equities in which insurers had invested heavily
(unlike their US counterparts) as capital reserve.
The terrorist attacks starting on 11th September 2001 which led to heavy
insurance claims.
The impact of SARS.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 53
Because of regulatory requirements, the insurers had to sell off their holdings but the
uncertainty around the amounts to be sold and the timing of the sales precipitated price
declines, further destabilising the stock market as a whole. The result was trading equities
out of the need for capital, which is a dangerous phenomenon, one that also led to stock
market drops in 1987 and 1998.
7
The serious need for capital by insurance companies was an abrupt change from the past
situation where the insurance industry was a provider of capital.
In order to alleviate shrinking capital reserves, and raise capital, the insurance industry
responded in a variety of ways:
Raising premiums: increasing their prices for insurance coverage.
Restricting insurance cover: increasingly, more and more scenarios and/or
events are not covered by insurance contracts leaving people and companies
with little or no coverage for some risks. The result is that more often individuals
and companies have to pay themselves the cost of certain events. Clients have
found that risks that were once covered by their policy, now are not, and are
becoming dissatisfied.
Issuing stocks and bonds: insurance companies are raising cash by issuing
equities and bonds. In 2003 insurance bonds were worth more than $ 9.6 bn,
8
but
given the current unstable state of the whole industry, it is unlikely more bonds
will raise much.
Pension insurance gap: pension funds that invested in shares saw the value of
their assets change with the ups and downs of the stock market. 2003 saw signs
of economic recovery from the three years of losses previously, however a gap to
cover all future obligations still exists. The global pension fund gap is between
$1,500 bn to $2,000 bn, so on average, pension funds are still underfunded by as
much as 20% and it could take up to 5 years to close the gap. Another "problem"
for pensions is that people are living longer and therefore draw on their pensions
for more years than previously.
9
Shift in business: the insurance industry has shifted business from life insurance
coverage to annuity products. This fundamentally changes the way life insurance
firms do business, as they concentrate on managing the investment risk, rather
than on the mortality risk of an individual. As a result, insurance firms now
compete more directly with financial services firms.
10
Technology changes that move the sector
Technology has had a major impact on changes in the financial industry in the way it sells
products and in the way it operates, both internally and externally. Technology is vital to
the workings of the many complex products (e.g. derivatives) and transactions (security
trading).
Electronic transactions have more than doubled since 1995 and they are expected to
double again by 2005. Internet banking is becoming more and prominent, as both large
and small banks offer web sites where customers can access accounts and buy financial
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 54
products. Several web-only banks have also popped up, including NetBank, Egg plc. and
ING Direct.
11
However there are still some technical problems to be solved including:
safety and security in e-finance on the internet,
coordinating different software between different divisions,
coordinating the technological integration after a merger or acquisition.
2.2 Structure of the financial industry: rankings of top
financial firms
The following rankings and tables provide an overview of those dominant companies in
the financial services sector worldwide. They are the financial conglomerates that buy, sell
and trade the most financial products described in chapter 1 above. They are also the
strongest proponents of deregulating of the financial markets and liberalisation financial
services (see chapter 6).
2.2.1 World rankings
The ranking of the financial industry is complicated by the various ways to work out
rankings and the constant restructuring of the industry. The table of the ranking of the
largest financial firms in Euros does for instance not include the takeover of FleetBoston
by Bank of America (nr. 2 in the world, ranked by net profit) in late 2003. These merged
US financial firms will however not take over Citigroup as world number one. The
combination of J.P. Morgan Chase who decided to buy Bank One for $58 billion in
January 2004 is likely to become the second-largest bank in the US.
Table: Banks ranked by market capitalisation (US$ bn, 2005)
Rank Company Home country Market value (US$
bn)
1 Citigroup US 255.3
2 HSBC UK 178
3 Bank of America US 117.5
4 Wells Fargo US 97.5
5 Royal Bank of Scotland UK 90.2
6 UBS Switzerland 85
7 JP Morgan Chase US 81.4
8 Wachovia US 62.3
9 Barclays UK 61.3
10 BNP Paribas France 59.3
Source: Forbes 2000 list, April 2005, at: www.forbes.com
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 55
Table: Banks ranked by assets, 2005
Rank Company Home country Assets (US$ bn)
1 Citigroup US 1,264.03
2 Mizuho Financial Japan 1,115.90
3 Sumitomo Mitsui Financial Japan 868.42
4 Mitsubishi Tokyo Financial Japan 827.48
5 J.P. Morgan Chase US 792.70
6 Barclays UK 791.54
7 HSBC Holdings UK 757.60
8 BNP Paribas France 745.09
9 Bank of America US 736.45
10 HVB Germany 705.36
Source: Forbes 2000 list, May 2005, at: www.forbes.com
2.2.2 A short analysis of the world top financial
conglomerates
Citigroup, the first truly global allfinanz conglomerate, dominates each ranking.
Citigroup’s large size was created in 1998, in anticipation of more bank deregulation in
1999, when Travelers Group insurance bought retail and commercial bank Citicorp and
created Citigroup. It is now active in more than 100 countries in all kind of financial
activities.
Bank of America is less internationally oriented than Citigroup with a presence in 30
countries (incl. the US, 5 in Latin America and 7 in Asia)
12
. It has the most extensive
network of bank branches in the US.
All of the top financial firms are the result from a series of mergers and acquisitions, trying
to use the network of one firm to reach clients for the other firm (e.g. J.P. Morgan Chase
was formed by bank Chase Manhattan buying investment bank J.P. Morgan in 2001).
Japanese banks are still highly ranked according to assets. Large mergers took place
last decade such as Dai-Ichi Kangyo Bank, Fuji Bank, and Industrial Bank of Japan which
merged to form Mizuho in 2001. In 2004, Mitsubishi Tokyo Financial Group and UFJ
Holdings, struck an agreement to merge. This merger will lead to the world's biggest bank
in terms of assets. . However, experts state that Japanese banks are the weakest,
together with the German banks, of the developed countries. This is the case since the
Japanese banking system has serious non performing loans problems, and have suffered
heavy losses in recent years ($39 bn in 2002).
13
In the Forbes ranking (that also takes
sales, profits and market value into account) the first Japanese bank on the list is
Sumitomo Mitsui Financial at rank 396. In 2004, the position of Japanese banks slightly
improved; instead of losses like in the years prior the 113 Japanese banks in the Forbes
1000 list managed to make net profits aggregating to $14,9 bn.
14
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 56
New comers in the future might be Chinese banks as some are currently being (partly)
privatised and bought up by foreign financial firms. The International Commercial Bank of
China (ICBC) is the largest commercial bank in China and would rank in the top ten
commercial banks worldwide based on assets.
15
In terms of quality, the Hongkong and Shanghai Banking Corporation (HSBC) won the
Global 2004 Bank of the Year Banker Award and the 2004 Global Bank award. Citigroup
wan different other awards such as the Global Finance Magazine's awards for Best Global
Corporate Bank and Best Global Exchange Finance Bank.
Many of the above mentioned financial firms are also high in ranking of the world’s biggest
companies in all sectors. Again, Citigroup ranked first as the world’s largest multinational
measured by a composite of sales, profits, assets and market value in March 2004.
Twelve (60%) of the 20 biggest companies in the world were financial firms. Of the 100
biggest global companies, 41% (41) were financial firms with a total net profit of US$
166.9 bn.
16
Table: Ranking of all financial firms according to Forbes 2000 list of the world
largest companies (US$ bn, March 2004)
World
company
ranking
Name Country Category Sales
($bn)
Profits
($bn)
Assets
($bn)
Market
value
($bn)
1 Citigroup United
States
Banking 94.71 17.85 1,264.03 255.30
3 American
Intl Group
United
States
Insurance 76.66 6.46 647.66 194.87
6 Bank of
America
United
States
Banking 49.01 10.81 736.45 117.55
7 HSBC
Group
United
Kingdom
Banking 44.33 6.66 757.60 177.96
9 Fannie Mae United
States
Diversified
financials
53.13 6.48 1,019.17 76.84
11 UBS Switzerland Diversified
financials
48.95 5.15 853.23 85.07
12 ING Group Netherlands Diversified
financials
94.72 4.73 752.49 54.59
14 Berkshire
Hathaway
United
States
Insurance 56.22 6.95 172.24 141.14
15 JP Morgan
Chase
United
States
Banking 44.39 4.47 792.70 81.94
18 BNP
Paribas
France Banking 47.74 4.73 745.09 59.29
19 Royal Bank
of Scotland
United
Kingdom
Banking 35.65 4.95 663.45 90.21
20 Freddie
Mac
United
States
Diversified
financials
46.26 10.09 752.25 44.25
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 57
25 Wells Fargo United
States
Banking 31.80 6.20 387.80 97.53
27 Barclays United
Kingdom
Banking 33.69 4.90 791.54 61.33
28 Morgan
Stanley
United
States
Diversified
financials
33.00 3.64 580.63 64.81
34 Deutsche
Bank Group
Germany Diversified
financials
58.85 1.53 792.49 50.23
36 HBOS United
Kingdom
Banking 32.68 3.09 571.76 52.87
39 Banco
Santander
Central
Spain Banking 28.70 3.28 442.24 56.78
40 Merrill
Lynch
United
States
Diversified
financials
26.64 3.47 485.77 57.52
41 Wachovia United
States
Banking 24.47 4.25 400.87 62.35
47 Lloyds TSB
Group
United
Kingdom
Banking 24.48 2.87 406.99 48.11
48 ABN-Amro
Holding
Netherlands Banking 23.64 3.98 704.95 39.29
50 American
Express
United
States
Diversified
financials
24.17 3.00 175.00 68.89
52 Bank One United
States
Banking 21.04 3.40 290.01 58.38
53 AXA Group France Insurance 90.10 1.00 456.13 41.39
54 Société
Générale
Group
France Banking 35.52 1.61 526.54 40.61
56 Goldman
Sachs
Group
United
States
Diversified
financials
22.84 2.54 394.14 50.12
57 BBVA-
Banco
Bilbao
Vizcaya
Spain Banking 24.10 2.81 288.80 44.67
59 MetLife United
States
Insurance 35.79 2.24 326.84 26.34
62 Allstate United
States
Insurance 32.15 2.73 134.14 32.90
67 Washington
Mutual
United
States
Banking 18.01 3.88 275.18 39.69
68 Crédit
Agricole
France Banking 31.77 1.12 531.01 38.80
73 Munich Re Germany Insurance 45.85 1.14 191.33 26.63
77 US United Banking 14.57 3.73 189.29 52.88
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 58
Bancorp States
79 Royal Bank
of Canada
Canada Banking 18.82 2.28 305.01 31.82
86 Natl
Australia
Bank
Australia Banking 15.34 2.69 269.94 36.51
90 FleetBoston
Finl
United
States
Banking 14.22 2.13 196.40 47.19
92 UniCredito
Italiano
Italy Banking 16.53 1.89 223.60 33.53
96 Fortis Netherlands Diversified
financials
52.51 0.56 507.98 30.19
98 Aegon
Insurance
Group
Netherlands Insurance 17.75 1.63 266.59 23.49
99 Dexia Belgium Banking 19.62 1.36 368.37 21.64
Source: Forbes 2000 list, March 2004, at www.forbes.com: measuring based on a composite of
sales, profits, assets and market value; including some figures of net profits in 2003.
Critical issues
Citigroup the top player
Citigroup's domination of the financial sector is significant. Citigroup's net profits
in 2002 and 2003 exceeded those of the second bank ranked by net profit, Bank
of America, by more than 60%. The sales of Citigroup are the same as those of
ING Group but Citigroup makes almost 4 times more net profit. This puts pressure
on the other financial firms to try and achieve ever-higher profits while continually
expanding. Citigroup might become the model and benchmark for others.
American and European financial firms dominate
The top 100 financial firms are completely dominated by those from the US and
Europe. It raises the question how much capacity banks from developing
countries might have to compete internationally against these large players.
Financial groups dominate world ranking
The fact that more than 40% of the 100 top world companies are financial firms
indicates how their current strategies are successful in making profit. The net
profit of all these 41 top financial firms is just less than the GDP of Denmark and
more than the GDP of for instance Hong Kong China, Greece, Finland, Thailand
and most developing countries.
17
The financial sector is more than other sectors
able to raise in the ranks of top world multinationals. In a world where stock
markets and share values are globalised, this puts constant pressure on
companies to increase profits.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 59
2.2.3 Regional rankings
Top European banks
The major European players at the top financial markets in Europe are HSBC (UK),
France’s Crédit Agricole, Royal Bank of Scotland and Deutsche Bank. ING Group (NL),
UBS (Switzerland) and HBOS (UK) are also top players in Europe.
18
Increasing presence of Western banks in Africa, Asia and Latin America
In Latin America, Africa and Asia, analysis shows that the top players are still banks from
their own region. But more and more Western players are taking a share of the market.
For instance, foreign financial firms that have become important in many Latin American
countries are Spanish Banco Santander, Banco Bilbao de Vizcaya (BBV) and Banco
Central Hispanoamericano, as well as HSBC (UK), Bank Boston (US), Sudameris (FR)
and ABN Amro (NL).
19
Citigroup became the dominant player in Mexico.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 60
A small company profile of a large financial conglomerate: Citigroup
20
Citigroup has dominated the financial services world for the last five years,
21
with net profits at
$ 17 bn in 2003. Citigroup's profits rose 17% compared with the year 2002.
22
Citigroup's net
profit in 2002, if compared with countries’ GDP, would rank 76 in 2002 with Serbia and
Montenegro at 75 and Belarus, El Salvador, Panama and Kenya among the countries
following.
Operational in more than 100 countries, well ahead of all others, it has the greatest distribution
capacity in the world. The group brings together banking, insurance and investments in one
corporation to offer a diversity of financial products.
Ambitions?
Citigroup was the first financial corporation to have establishments in all EU countries for
corporate banking activities even though it was American.
23
As explained to the Financial
Times, Citigroup has the ambition “to reach top ranking for every product it sells and in every
category it services in all regions”. Citigroup wants to increase revenue across the globe by an
additional $ 130 bn a year from potential fees for its corporate and investment bank business.
Citigroup’s CEO recently said the future strategy would be to make smaller rather than larger
acquisitions, with a focus on ‘fill-in’ deals, which are small by his company’s standards.
Previous ‘fill-in’ deals include extending Citigroup's consumer banking reach, or for example
the purchase of Poland's Bank Handlowy and Mexico's Banamex. It is still up in the air as to
whether the Bank of America and FleetBoston merger will challenge Citigroup to take up larger-
scale acquisitions in the financial retail sector.
24
Size and outreach
To get to a grasp of the financial strength of the Citigroup, here are some figures: At the end of
2003, Citigroup’s assets totalled $ 1.264 trillion,
25
the company has 275,000 employees,
26
there are 200 million customer accounts in more than 100 countries, the company is the largest
provider of credit cards in North America, and it has more than 3000 branches worldwide, not
counting the 766 branches in the US.
Domination? Examples
Biggest global underwriter of bonds in 2003; arranged $ 41.9 bn in bond sales in 2003 fourth
quarter alone.
The top company in global equity offerings at the end of 2003; arranged $10.6 bn in initial
public offering of shares (IPO) deals.
27
Number 1 derivatives dealer.
28
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 61
Ranking of banks in Asia is dominated by four Chinese banks, followed by the Hongkong
and Shanghai Banking Corporations (HSBC, headquartered in the UK) and National
Australia Bank.
29
The positions in the 2003 top 100 Sub-Saharan banks are occupied by the "big five" South
African banks: Standard Bank Group, FirstRand Banking Group, ABSA Group, Nedcor,
and Investee. The major shareholder (14%) of Standard Bank is the Old Mutual Group
30
with activities in South Africa, the US, the UK and some other countries. Standard Bank is
the only South African bank with significant presence in the rest of the continent. Other
major Sub-Saharan African players are based Mauritius or Zimbabwe. Foreign banks with
a significant presence in Sub-Saharan Africa are Barclays (UK), Fortis (B-NL, via Banque
Belgolaise), BNP (F) and Société Générale (F).
31
2.2.4 Sectoral ranking
Project lending mostly done through European banks
32
, as opposed to project
bonds
Most project lending comes from European banks which financed US$ 70 bn in global
projects in 2003. Forty one billion US$ was allocated to European projects, mostly for
infrastructure in the energy sector. American banks are not very active in for project loans
because the profit margins are too small.
Table: World top financiers of project financing through credit
Rank Bank Country
1 Crédit Agricole/Crédit Lyonnais F
2 Royal Bank of Scotland UK
3 BNP Paribas F
5 Société Générale F
… Barclays UK
… WestLB D
Source: Het Financieele Dagblad, Kredietverlening aan grote projecten klimt uit het dal, 23 January
2004; based on data from Thomson Financial
Increasingly, projects are financed through bonds. In Europe, bond project financing grew
to $9 bn from $2 bn in one year. American banks beat the ranking for project financing
through bonds. In 2004, the best project-financing award from The Banker went to
Citigroup
33
.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 62
Table: World top project financiers through bonds in 2003
Ranking Bank Country
1 Citigroup US
2 Credit Suisse First Boston (CSFB) Switzerland
3 Lehman Brothers US
4 …
5 ABN Amro NL
Source: Het Financieele Dagblad, Kredietverlening aan grote projecten klimt uit het dal, 23 January
2003; based on data from Thompson Financial
Governmental institutions seeking project-financing advice are turning to accountants
rather than banks to cut costs. The top global advisors for project financing are:
Table: World top global advisors for project financing
Ranking Advisor
1 Ernst & Young
2 PriceWaterhouseCoopers
3 …
4 KPMG
5 ABN Amro
Source: Het Financieele Dagblad, Kredietverlening aan grote projecten klimt uit het dal, 23 January
2003; based on data from Thompson Financial
American investment banks dominate the global market
The top global players in investment banking are American financial firms, which include
Citigroup Global Markets (formerly Salomon Smith Barney), J.P. Morgan Chase, Goldman
Sachs and Morgan Stanley. The 2004 Banker Award for both the best Bond House and
best Equity House of the Year went to Morgan Stanley. Goldman Sachs received the 2004
Banker Award for the best activities in supporting and financing mergers and acquisitions
(M&A House of the Year).
The high fees make investment banking a very attractive business but many global
players from other countries have difficulties in competing with these US banks in their
investment bank activities. Since 1995, Japanese investment banks have been largely
driven out of all capital market services.
34
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 63
Table: Investment banking companies ranked by sales
Rank Company Country
1 Citigroup Global Markets US
2 J.P. Morgan Chase US
3 Goldman Sachs US
4 Morgan Stanley US
5 Merrill Lynch US
6 Credit Suisse First Boston Zwi
7 Lehman Brothers US
8 Bank of America Securities US
9 UBS Investment Bank Zwi
10 Deutsche Bank D
Source: Hoover’s Industry snapshots, Investment banking, [15 January 2004].
2.2.5 Global concentration in some financial services
sectors
Still many domestic financial firms compete with the large world players for various
products. However, in some financial services sectors, a few big players dominate the
business and prevent other financial firms to compete or enter the market. Such
'concentrated' or oligopolistic sectors include:
Credit derivatives market: Trading in the credit derivatives market is
concentrated among a small number of financial firms
35
. Especially the
investment bank arms of commercial banks such as Citibank and Morgan
Guarantee Trust do a large part of the intermediation between buyers and sellers
of credit risk protection. Most of the trade is done in London and New York.
Commercial banks are the main issuers of credit risk derivatives ( and thus net
buyers of credit risk protection), while commercial banks,insurance companies,
hedge funds and pension funds account for most of sales of credit risk
derivatives.
Rating agencies: Three rating agencies that analyze creditworthiness are each
most used and respected around the world.: Standard and Poor's corporation
('S&P'), Moody's Investors Service and Fitch Ratings. All of them are US based.
The top 10 property and casualty insurance companies, including State
Farm, Aviva, American International Group, and Zurich Financial Services
account for almost half of all premiums written. A decreasing number of local
firms are left to fight for the remaining scraps of market share.
European and American investment banks in South-East Asia have established a
oligopoly in two services in the regional capital markets:
underwriting in the primary market and distribution of new share issues
(investment banking),
trading in securities and bonds and consulting in the secondary market,
i.e. the market that deals with equities trade after the original issuance.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 64
From 1998-2001, American and European investment banks held 74% of
financing through capital markets, i.e. from shares, in five South East Asian
countries.
Concentration also tends to take place at the national level. Countries that have been
deregulating tend to have more and more mergers and acquisitions resulting in
consolidation and foreign take-overs. Financial services then tend to concentrate in a few
companies, as is the case in Hong Kong, Belgium and the Netherlands.
2.3 Trends and strategies: financial service companies
Information technology, deregulation and liberalisation have dramatically affected the
financial services industry contributing to two important trends namely, consolidation and
increased competition at both the national and international levels. These two trends
impact societies and economies, especially in relation to poverty eradication.
2.3.1 Consolidation
36
‘Consolidation of financial services’ means that financial services worldwide are
increasingly concentrated in the hands of a few corporations as described in the structure
of the financial industry above. Consolidation is seen as the single most important factor
transforming the financial services industry since almost a decade. Many experts predict
that consolidation will continue and within 5 to 10 years, there will be only five to ten top
financial conglomerates in the world.
In search of more profit opportunities, most consolidated financial firms did not so much
expand organically as grow through mergers and acquisitions or takeovers that were
either friendly or hostile. Such consolidation took place at national level and more
importantly at international levels with ‘cross-border consolidation’ by trading and investing
in financial services in many countries around the world. Also, many financial services
categories such as retail banking and insurance, were increasingly being brought under
one corporate roof which is called ‘cross-category consolidation.’
The strategies behind consolidation are:
Increasing the number of customers and beating competitors by selling various
financial products through one distribution channel (one stop shopping);
diversifying products and customers to avoid risk (like putting too many eggs in
one basket, if the basket breaks, the whole business might be lost) and to finance
a loss-making part of the business with the profits of another part of the business
(cross-subsidization);
maintaining a large capital base as buffer to absorb losses and absorb the
growing cost of technology;
increasing the quality of service and products to gain the trust of the customers;
increasing profitability not to loose out against competitors.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 65
The causes of consolidation are also political:
Governments (some under pressure from the IMF and World Bank) have opened
up their financial services for trade and investment by foreign competitors. Once
foreign financial firms take a share of the domestic market, domestic companies
try to expand their market by going abroad.
Governments have removed restrictions preventing different kinds of financial
services to be part of one financial corporation. In the US, the Glass-Steagall Act
(of the 1930s) and the Bank Holding Company Act (1956) were withdrawn.
State banks in developing countries are being privatized and state aid to financial
institutions is stopped e.g. in the EU due to rules of the European Single Market.
The introduction of a single currency such as the Euro has stimulated cross-
border activities and consolidation.
The new capItal accord agreed upon by Western central bankers regarding
capital reserves to cover loans ("Basel II": see chapter 5) wIll prIorItIze large
banks. ThIs Is the case because large banks will be able to use an internal risk
management system, and have to putless capital aside than smaller banks
without such systems. Smaller banks will have to use a standard approach that
requires to put aside much more capital than the larger banks. Smaller reserves
make the larger banks more profitable.
Liberalisation in trade and investment in financial services often leads to national banks
being unable to compete with internationally operating banks. As a result of consolidation,
the numbers of medium-sized banks and large national financial firms (as opposed to
mega conglomerates) can decrease even if they are the largest in a country. In most
OECD countries, consolidation has worked against existing medium-sized financial
companies through merging or being acquired by larger banks. In countries like the
Netherlands and Belgium consolidation has lead to a financial industry market dominated
by 5 financial groups.
Where governmental rules have not allowed consolidation however, foreign takeovers
have not taken place, as is the case in Italy or Germany.
37
Consolidation continues
Citigroup once declared it wanted one billion customers in ten years
38
and now has 200
million customer accounts worldwide, which is the clearest example of cross-category and
cross-border consolidation. The merger of Bank of America (US) and FleetBoston (US) at
the end of 2003 is another example of increasing competition and pushing smaller firms
out of the market. It was also seen as the start of a new wave of consolidation.
The more mergers and acquisitions, the more consolidation intensifies. When J.P. Morgan
Chase (US) decided to buy Bank One (US) in January 2004 to become the second largest
US bank after Citigroup, analysts wrote: "Citigroup was for the last two or three years
head and shoulders above the competition …We think Citigroup will now be prodded to do
a deal", while Citigroup had indicated it had only plans to make smaller strategic
purchases.
39
Consolidation across boarders is however often complicated by national
legislation, different currencies and corporate cultures.
40
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 66
One of the reasons why foreign banks are allowed to take over domestic ones is because
the foreigners promise to inject capital, better allocate resources and supply solid
management. This is especially attractive to developing countries, particularly during or
after a financial crisis.
Experts expect that, in the future, small financial firms with a clear local or regional focus
or high specialization might still make enough profit to keep their independence from
mega conglomerates and continue to exist.
The new battlefields
Consolidation will continue because new markets are opening.
China, perhaps the most interesting and the most lucrative market, is opening up after
Western financial firms successfully lobbied very extensively during China's accession
negotiations to the World Trade Organisation (WTO). Many top financial firms have
already acquired parts of those Chinese banking divisions as allowed under the
agreement.
41
Foreign banks, such as ABN Amro, tend to target rich clients.
42
Many
Western financial firms are involved in the restructuring of the Chinese banking sector.
Citigroup has bought a big share of many of the non performing loans (NPL) of the four
big Chinese state-owned banks. Morgan Stanley and Goldman Sachs have arranged joint
ventures with Chinese banks
43
. Obviously, they all hope to get a market share in this
huge, fast-growing economy.
Consolidating through mergers and acquisitions is rampant in Central and Eastern
Europe where regional and European banks are trying to extend their market share. The
biggest players are Austrian and Italian.44 Austrian banks have a clear strategy of making
acquisitions in Central and Eastern Europe. The Bank Austria Creditanstalt45 is protected
against political upheaval through the World Bank’s Multilateral Investment Guarantee
Agency (MIGA) Political risk insurance might be necessary when taking over privatised
banks. Privatisation of state banks, including peoples’ banks at the post office which have
always intended to give access to everyone, is taking place throughout the region. Some
bigger banks from Central and Eastern Europe are also taking over smaller ones and
those in neighbouring countries.
Only 25-30% of Russian adults have bank accounts leaving the rest of the country
stuffing money in their mattresses.
46
It remains to be seen how far Western financial firms
will adapt to Russian circumstances and can be trusted by Russians. Before the 1998
Russian financial crisis, foreign banks promised much but did deliver little.
When participating in national and regional consolidation, financial conglomerates
increasingly focus on core business in core regions. They are continuously selling off
inefficient or unprofitable units and buying new ones in their core business or region. And
where financial conglomerates cannot acquire or takeover and win a sufficient market
share, they tend to sell units off because each firm strives to achieve the top spot in its
core business and its core regions.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 67
Critical Issues
Big is not always better
Large, diversified financial companies operating in many countries are more
difficult to manage and control. Different financial services have different risks
(banking risks are not the same as risks in insurance) and new management
might lack the necessary expertise.
Mergers and acquisitions can fail
Merging different corporate cultures is not always smooth or successful.
Research shows that in general more than 50% of corporate mergers and
acquisitions fail.
Risky business
It is risky creating financial firms that are difficult to monitor and “too big to fail.”
Bankruptcy of such conglomerates is often prevented even if the banks are
mismanaged. To prevent shock waves throughout the economy when the
conglomerate falls into trouble, governments become the “insurer of last resort” or
hold deposit insurance schemes. This means tax payers pay the bill and losses
are ‘socialized’, while on the other hand, profits are privatised.
Banks get political power
Generally, the concentration of economic power in a few consolidated banks
increases their political power. Governments are also dependent on financial
conglomerates for loans and bond underwriting. The political power of the
financial industry is evident from the lobby against debt restructuring (see chapter
5) and in favour of international liberalisation of financial services in the GATS
(see chapter 6).
Conflicts of interest
While integrated banking brings benefits like reduced costs, product diversity and
cross-subsidisation of different activities within the financial company, it also
brings conflict of interest between the different services for which some
investment banks have been indicted (see chapter 1: Scandals at financial firms).
Complicated regulation
Cross-border and cross-category consolidation complicates the work of financial
regulators and supervisors at national and international levels. The growing
number of financial conglomerates, particularly those active in several countries
require proper handling (both preventive and corrective) by the regulatory and
supervisory financial institutions as well as effective coordination and cooperation
between supervisors within one country, and between the national supervisors in
different countries. At the moment, an ideal regulatory environment, which
functions at the various levels, does not exist (see chapter 5).
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 68
Little evidence of knowledge transfer
Contrary to what is mostly argued
47
, experience shows that a foreign takeover of
a financial service provider does not always lead to a transfer of knowledge and
skills to local banks. Most foreign banks tend to attract the more experienced
personnel from domestic banks and other foreign banks in the host country than
they lose personnel to those local banks. China has experienced the brain drain
on the domestic banks when foreign ones enter the market (see chapter 6).
Will prices, eventually, increase?
High concentration of economic power leaves governments and customers little
choice, which might lead to an unnecessary price increase. During the first phase
of competition prices should fall, but later, when only a few players dominate the
sector, tacit price-fixing will drive prices back up. This is not a hypothetical
scenario. Secret price-fixing has occurred repeatedly, even if it only seldom
comes to light, as it did recently in Germany. Authorities reported that the
insurance companies Allianz, Gerling, HDI, Axa, Aachener, Münchener, Gothaer
and Victoria, illegally price-fixed as their industrial customers found out. Allianz
board member Hagemann has now admitted: “There were informal contact
groups.”
48
Encouraging risky lending
Consolidation combined with strong competition among financial services leads to
difficult dilemmas. It may enhance the efficiency and lending of the banks and
lower prices for consumers and the whole economy. But more competition also
tempts banks to engage in riskier lending (as was the case in the Asian financial
crisis), and other practices that destabilise the banking industry, which has very
costly repercussions for the whole economy.
Problems in implementing competition policy
Increasing consolidation also leaves difficult dilemmas for financial supervisors
and the implementation of competition policy. In small countries, competition
policy officers might block mergers and acquisitions to prevent domination in the
domestic financial market. At the same time, allowing a domestic financial firm to
become dominant might be the only way to avoid takeovers by foreign financial
firms. Sweden and the Netherlands have allowed for the creation of a few
"national champions". The Dutch banks have subsequently become important
international players.
Top ranked financial firms active in financial sectors where only a few operate
might engage in anti-competitive activities such as price fixing (directly or
indirectly by following the others’ price changes), and anti-competitive cross-
subsidisation. However, at the global level, there is no broad competition authority
that deals properly with global anti-competitive practices. Intervention from the
national country might not be sufficient to tackle the problems.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 69
Only out for profit
Consolidation takes place where profit will be made. Foreign financial firms
consolidate in developing countries to try and win a significant part of the market
share and earn profits. They will not invest or waste time in a country where there
are no profits to be made.
High technology costs
Merging technologies of two financial firms after takeovers and within
consolidation phases is expensive and complicated. The various parts of the
financial firm need to match and integrate systems with other solutions used
across the bank. Coping with the many changes the financial industry faces
49
is a
huge challenge. At the same time, large middle market banks have started
offering improved global payment services as increasingly small and medium
sized industries find business overseas, making the very small business market
underserved.
50
Increasing intra-firm cross-border flows
Transactions and lending around the world, between different parts of the same
company, accounted for a major increase in capital flows during 2003.
51
2.3.2 Competition
Consolidation is the financial industry’s way of dealing with increasing competition.
Governments, regulators and supervisors worldwide try to create and maintain a free
market with many competitors, all in the name of efficiency and lower prices. However, the
financial service sector does not only compete but has been cooperating among
themselves through increase strategic alliances and consolidating.
52
Competition nevertheless remains fierce. The struggle is always for quicker and short term
profit which leads to strategies for more efficiency, lowering costs, expansion of profit
making clients and markets, and "killing" the competitors. The results are, as explained in
chapter 1, as follows:
Cost cutting in services such as closing branches, standardization and
automation of services.
Cost cutting in personnel, which often leads to firing people and sometimes to
lower labour conditions.
Market segmentation: divides up level of services according to the wealth of the
client.
Focus on the richest clients and scale down services to the poor: some
financial firms chose to focus on a few very lucrative services like investment
banking or high technology transaction processing, and offer no lower-margin
traditional banking operations.
Shifting focus: When people started to put more of their cash into mutual funds
and securities rather than deposit accounts, banks of all sizes became more
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 70
dependent on fee-based services. Once the stock market bubble burst, the fee
income from underwriting, acquisition deals and trade in securities had diminished
so much that financial conglomerates turned their attention again to retail banking
and branches.
Cross-selling: offering a diversified packet of financial services to woo and keep
clients.
Cross branding and 'cooptition': Some financial have started to distribute
financial products for their competitors without operating them. For example,
Deutsche Bank is selling the mutual fund products of its rival Fidelity.
53
The larger
and more diversified financial firms are increasingly working together in
cooperative technology ventures for all kind of consumers. For instance, Merill
Lynch and HSBC set up a joint venture for online wealth management service.
54
Outsourcing: to reduce costs, financial firms start to outsource some of their
internal operations, e.g. IT activities, or some of their financial products to other
(financial) firms, often in emerging markets like India
55
.
High costs for technology: In order to offer the most attractive services and
manage the diversified and geographically spread products and operations,
financial firms need to constantly invest in new technology while having to cut
costs in other parts of the firm.
Critical issues
Cherry picking by the foreign financial industry
Rich clients, the best managers and personnel are often cherry picked by foreign
companies. Providing mainstream clients with good service is not a strategic
focus. The rich get the best, which can be particularly pronounced in developing
countries where the poor are excluded from foreign financial services (see
chapter 6 on liberalisation of financial services and GATS). Arguments of
‘efficiency’ on behalf of the authorities and financial industry mostly benefit the
wealthy and the largest corporations
Standardization and automation
Automation in practice can marginalize the poor and seniors who have no access
to internet or computers, or who do not know how to use the machines. Also older
people often fear they will be attacked when taking money on the street. Poor and
young people are often targeted to take out easy, small loans through non-
personal standardised products. When they have problems with repayment,
banks exclude them from other services.
Need for more supervision and regulation
According to experts advising central banks
56
, when competition affects economic
stability, normally the appropriate safeguard is sound prudential regulation or
good corporate governance, rather than limiting competition. Research indicates
that many countries do not have the necessary regulatory and supervisory
systems to address many new problems that arise from the competition.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 71
Moreover, regulators' and supervisors' instruments are mostly assessing the risks
of financial instability, with too little focus at the impact of competition on universal
access, quality of service to the poorer clients and good financing of small and
medium-sized producers.
Moral hazard
Moral hazard is one of the most serious problems at both the national land
international levels.
57
To stay competitive, banks take many risks, as was the
case in South East Asia when competition for new lucrative markets lead Western
banks to increase their highly risky lending in the belief that governments would
intervene if loans defaulted.
States want to protect their citizens against bankruptcy and banking instability,
and prevent people from loosing their savings and being affected by a
devastating economic crisis. At the same time, governmental risk protection
mechanisms -such as deposit insurance systems- tend to encourage banks to
take excessive and dangerous risks. But when losses result from excessive risk
taking, financial firms get "bailed out" at the national level by government safety
nets and at the international level by the IMF. Both are done with money from
taxpayers’, not from the risk takers or the banks that caused the problems.
The balance between protecting innocent citizens against major financial risk and
allowing risky activities of financial companies is the task of national and
international financial regulators and governments. There is however still much
work to be done in developing a financial architecture, which is fair and balanced
(see chapter 5).
Unequal competition in developing countries
When foreign banks enter a new market, their national competitors are often
much less advanced and although increased competition stimulates efficiency,
some domestic banks just cannot compete as is the case for investment banking.
In developing countries, but also in places like Japan, many people simple don’t
trust national banks and put more of their trust, and savings, into foreign banking
services.
The risks of increasing interdependence
The large complex financial conglomerates have become more interdependent,
which means the whole financial system and economy, or systemic risk, is at
stake should one conglomerate face troubles.
Interbank loans, syndicated loans, group underwriting, trading derivatives over the
counter (OTC) with other financial firms, re-insurance, cross branding,
outsourcing, and payment and settlement systems are all examples of increasing
interdependence. Combined with consolidation, financial services become
increasingly more clustered and confusing.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 72
2.3.3 Shareholder value
Many financial firms are listed on the stock market. Their shares are therefore in the
hands of individual investors and mutual funds, both of which could be other financial
firms. Cross ownership /cross shareholdings, in the Netherlands for example, is notorious
and raises questions about real competition and corporate independence.
Share price and share value, regardless of whether the goal is to maintain or increase the
value, is a constant, fundamental concern of the top management of all listed companies,
including those in the financial services sector. When the value of shares falls too low, a
company can be subject to a take over (friendly or hostile) by another bank that buys up
the "cheap" shares. For example, ABN Amro became a world player after consolidation
took place in the Netherlands but feared that low share value put it at risk of being taken
over. In early 2000, the CEO said that the new strategy would focus on shareholder value
and increase profits annually by a minimum of 12.5%! At the height of the economic boom
the bank was indeed able to record a profit of Euro 2.5 bn in 1999, or a 40% increase in
profit compared with the year prior.
58
Even then, thousands of people were laid off. When
the stock market dropped and the economy slowed down at the end of 2001, the CEO had
to adapt his strategy. Nevertheless, his salary was increased.
Shareholder pressure is an important element in the management of (financial) firms.
Shareholders and investors often want to see short-term gains and press for more
efficiency. When cost cutting strategies are announced and people get fired, often at the
behest of shareholder pressure, investors react enthusiastically and share value
increases. This scenario is a disincentive for management to focus on the social or
environmental impacts of the company. Shareholders, therefore, are the most influential
stakeholders in a company.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 73
2.4 Conclusions and critical issues
1. Unequal competition
The top world players in the financial industry are US and European banks, insurance and
'allfinanz' firms. Japanese banks do no longer belong to the top as they were 10 years
ago. It becomes very difficult for the financial industry of other countries and regions to
become part of the world players and 'to enter to world market' in financial services.
Specific sub-sectors such as investment banking and rating agencies are concentrated
world wide in the hands of a few, often US, financial firms. As a result, many domestic
banks cannot compete against these specialized firms when they enter their countries.
While there is still a large choice of commercial banks in some countries (Germany, Italy),
other countries (e.g. the Netherlands, Sweden) have their financial industry concentrated
in the hands of a few.
2. Citigroup is the biggest of all
The biggest world player of the financial industry has for some years been head and
shoulders above the others: Citigroup. Citigroup's net profits in 2002 and 2003 exceeded
those of its nearest contender by more than 60%. Citigroup’s strategy of activity in all sorts
of financial services and in more than 100 countries worldwide, as well as its profit-
.making strategies, is influencing the profit expectations of the other world wide financial
firms.
3. On top of the world's multinationals
Compared to other multinationals, Citigroup is first on the Forbes 2000 list that measures
companies based on a composite of sales, profits, assets and market value. Financial
conglomerates take 60% of the top 20 companies in the world and more than 40% of the
top 100 companies. This shows the profit making capacity of the international financial
industry while it remunerates its managers and traders with excessive pay.
4. Current key trend of consolidation diverts efforts towards sustainable
development
The single most important factor transforming the financial services industry since more
than five years is consolidation. This trend is expected to continue and result in only five to
ten top financial conglomerates in the world within a decade. Top financial firms are now
acquiring many banks and other financial services in many countries. China, Central and
Eastern Europe and Russia are the new regions to be part of this trend. Domestic banks,
however large, that are not consolidating across sectors or across borders are expected to
loose out. The fierce international competition among the top financial industry to win the
battle of consolidation has lead to many cost saving and focus-on-the rich strategies.
The marginalization of the poor customers and the lack of attention to sustainable
development are thus part of the current key strategy within the financial industry. Making
the financial industry more instrumental to sustainable development and poverty
eradication might be difficult and contrary to consolidation that bends the sector to bigger,
faster, more.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 74
5. Risks need more attention
While the positive aspects of consolidation -more efficiency, lower prices and more choice
of new products - are highlighted, the (potential) negative consequences are still not
solved. Will financial firms become too big to fail and need intervention with taxpayers'
money when they mismanage? Will they become too big to compete and reduce choices
or abuse their market power e.g. by fixing prices among themselves? Already many forms
of strategic alliances and interdependence enhance the effects of consolidation contrary to
the 'free markets' which governments want to create.
6. Mismanagement of risks
The financial industry has gone through some rough years in 2001 and 2002 due to the
falling stock markets. Especially the loss making at the European insurance industry was
cause of concern. This means that the stability of the financial sector has been made too
dependent on the value of the stock market and that financial firms had mismanaged their
risks. If continued, this could have severe consequences. This mismanagement, together
with the recent scandals, calls for more regulation and supervision, which also should be
the case when they further expand to developing countries. The new upsurge in profits in
2003 might take attention away form these risks.
7. Focus on shareholder value, not on society
Consolidation has increased the focus on high shareholder value of the financial industry.
High shares mean less chances of being taken over. The constant focus on shareholder
value leaves little attention to sustainable development in the societies in which financial
firms operate. Not surprisingly, the industry stated in 1999 that the interests of society
should be taken care of by governments while they focus on share holder value
maximization (see chapter 4 for further developments on this issue). The latter makes the
shareholders the most influential stakeholders while they have little interest in sustainable
development and poverty eradication.
8. What will the future bring?
Possible scenarios for the future of the global financial industry are, without being mutually
exclusive:
The trend towards globally active universal financial service providers continues
with more cooperation among the few left. At the same time, mid-sized banks
disappear and the non-profit making countries and poor clients are less and less
served.
(Small) specialized financial firms survive: emergence of more functionally
specialized financial firms within a segment of the financial industry that survive
the competition of the large universal players.
Continued consolidation but a more radical form of specialization through the
gradual 'deconstruction' of the supply chain via the outsourcing of certain
activities (e.g. Internet services) to both financial and non-financial parties.
risks become too high and financial conglomerates destabilize economies;
regulators and supervisors -under pressure from public opinion- become more
active to discipline and undo the consolidation of the financial industry.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 75
1
Hoover's Industry Snapshots, Banking, 2003.
2
BIS, The international banking market, in Quarterly review, December 2003, p. 13, 18.
J
Top 1000 World Banks, in The Banker, 2 July 2003.
4
Europe slow to follow:the top 300 European banks, in The Banker, 3 September 2003.
5
See for instance: D. Wigton, Goldman’s record earnings round off bumper results, in FT,24 March
2004.
6
German News, English edition 26 June 2003,
(http://www.germnews.de/archive/dn/2003/06/26.html#9_)
7
BIS, 73rd Annual Report, p.104.
8
Lex Column, in The Financial Times, 25 September 2003, p.24.
9
S. Targett, Pension gloom is lifting, in FTfm, 19 January 2004, p. 2.
10
Insurance: risk management, The Financial Times Report, 1 October 2003, p.2; Lex Column, in FT, 25
September 2003, p.24.
11
Hoover's Snapshots, banking, 2003.
12
http://www.bankofamerica.com/facts/index.cfm?Menu_Sel=globalmap
1J
Top 1000 World Banks, in The Banker, 2 July 2003.
14
The Banker, Top 1000 world banks, 2 July 2004, through www.thebanker.com
15
M. Harmsen, De Nederlandse banken nemen posities op de Chinese markt in, in De Telegraaf, 22
August 2003.
16
Forbes 2000 list, March 2004, at: www.forbes.com
17
see World Bank, World Development Indicators database, July 2003.
18
Europe slow to follow:the top 300 European banks, in The Banker, 3 September 2003
19
Newcomers stand out in ranking of foreign banks in Latin America, quoting Foreign Investment in Latin
America and the Caribbean, ECLAC, 1998; confirming what newspapers are reporting up to 2003.
20
For a comprehensive profile, see SOMO's analysis of Citigroup at www.somo.nl
21
Top 1000 World Banks, in The Banker, 2 July 2003.
22
Citigroup, 2003 Annual Report, March 2004.
2J
H. Onno Ruding, The transformation of the financial services industry, Financial Stability Institute (Bank
for International Settlements), Occasional paper nr 2, March 2002, p. 12.
24
Citigroup not looking for a mega-deal, in Retail Banker International, 27 November 2003, p.2
25
Citicorp 4th-qrt profit rises 96% to 4.76 billion (update 3), Bloomberg.com, 20 January 2004; see also
Forbes 2000, March 2004.
26
www.citigroup.com/citigroup/business/index.htm
27
Citicorp 4th-qrt profit rises 96% to 4.76 billion (update 3), Bloomberg.com, 20 January 2004
28
Award from Institutional Investor, in: Citigroup 2003 Annual Report, March 2004
29
The Banker, Top 200 Asians, [December 2003], at
www.thebanker.inta.net.uk/rankings/top_200_asian[/index_print.shtml]
J0
see also www.oldmutual.com
J1
The Banker, Top 100 Sub-Saharan African Banks, December 2003; The Banker, South Africa still on
top, 2 December 2003.
J2
Analysis based on Het Financieele Dagblad, Kredietverlening aan grote projecten klimt uit het dal, 23
January 2003; based on data from Thompson Financial.
33
See www.thebanker.com
J4
Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 204, table 12.
J5
J. Kiff and R. Morrow, Credit derivatives, in Bank of Canada Review, Autumn 2000, p. 6.
J6
See: H. Onno Ruding, The transformation of the financial services industry, Financial Stability Institute
(Bank for International Settlements), Occasional paper nr 2, March 2002.
J7
M.Veeger, Italiaanse banken zijn boeven, in De Financieel Economische Tijd, 30 April 2003.
J8
M. Vander Stichele, Is de financiële crisis voorbij?, SOMO, November 1999.
Critical Issues in the Financial Industry
Chapter 2 – Insights in the financial industry: trends and strategies 76
J9
Citicorp 4th-qrt profit rises 96% to 4.76 billion (update 3), Bloomberg.com, 20 January 2004
40
H. Onno Ruding, The transformation of the financial services industry, Financial Stability Institute (Bank
for International Settlements), Occasional paper nr 2, March 2002, p. 10.
41
One of the strategies is joint ventures as the Chinese authorities still prohibit full ownership and restrict
many financial services provisions by foreign financial corporations. These restrictions will be taken
away from 2006 onwards following agreement with the WTO (agreed during accession talks).
42
M. Harmsen, Nederlandse banken nemen posities op Chinese markt in, in De telegraaf, 22 August
2003.
43
The Banker, Foreign banks line up to invest in Chinese UCBs, October 4
th
2004; The Banker, HSBC’s
$1.75bn investment in Bank of Communications, February 2
nd
2005; The Banker, The winning ways of
a profit generator, December 1
st
2004; available at www.thebanker.com
44
Europe slow to follow: the top 300 European banks, in The Banker, 3 September 2003
45
See for instance: Bank Austria announces net income before taxes rises to EUR 280 million for 2002,
in The Asian banker Journal, 31 March 2003. See also http://thebanker.pressflex.com: Bank Austria
Creditanstalt received the The Banker award for Central and Eastern Europe.
46
N. Guy, [n.a.], in Euroweek, 14 March 2003, p. S2. In Western Europe, more than 90% of the adults
have a bank account. Russians keep at least $ 60bn worth of hard currency, principally dollars in
hiding.
47
See for instance BIS, Foreign direct investment in the financial sector of emerging market economies,
Report submitted by a Working Group established by the Committee on the Global Financial System,
March 2004.
48
Frankfurter Rundschau, 31 July 2003.
49
See for instance: F. Maguire, Research highlights lack of core banking systems, in Financial News, 2
July 2003.
50
M. Sisks, Consolidation: web techies brace for M&A storm, in Bank Technology News, July 2003, vol.
16, nr. 7, p. 12.
51
BIS, The international banking market, in Quarterly review, December 2003, p. 14.
52
Group of Ten, Report on consolidation in the financial sector, January 2001, p. 2.
5J
T. Major, F. Gimbel, Germany flocks to one-stop shops, in FTfm, 16 September 2002, p. 7.
54
I. Wylie, A modern industrial revolution, in The new new deal, a guide to global investing online,
sponsored by Merill Lynch HSBC, supplement, May 2001, p.4.
55
Basel Committee on Banking Supervision, Outsourcing in Financial Services, February 2005, at
www.bis.org
56
M. Canoy, M. van Dijk, J. Lemmen, R. de Mooij & J. Weigand, Competition and Stability in Banking,
CPB (Netherlands Bureau for Economic Policy Analysis) Document nr. 015, December 2001.
57
See for instance H. Onno Ruding, The transformation of the financial services industry, Financial
Stability Institute (Bank for International Settlements), Occasional paper nr 2, March 2002, p. 15.
58
Myriam Vander Stichele, De rol van internationale banken bij 'pro-poor growth', a SOMO paper in
preparation of the debate on Ondernemen tegen armoede, The Hague, January 2001.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 77
Chapter 3
The case of Indonesia
Introduction
There are some issues in the private financial sector that are particular to developing
countries and which are important from a perspective of poverty eradication and
sustainable development. This chapter is a summary of a case study of the financial
services sector in Indonesia by Business Watch Indonesia
1
and raises some specific
critical issues.
3.1 Domination of the banking sector compared to other
financial services
In Indonesia, as in many developing countries, the banking sector dominates the private
financial sector. Not many other financial services are offered. Rarely are insurance
services provided to individuals and companies. So, the banking sector is an important
motor for business life and economic development.
Table: Map of the financial sector in Indonesia in 2002
Rank Sector Controlling market share
(%)
1 Banking 90.46
2 Insurance Company 3.38
3 Pension/Pension Fund 3.01
4 Multi-finance company 2.31
5 Securities Company 0.65
6 Pawn shop 0,20
Source: Business Watch Indonesia, based on InfoBank, Nr. 292 - August 2003, Vol.XXV.
3.2 The role of banks in servicing the poor
3.2.1 Weak support for small and medium sized enterprises
Small and medium sized enterprises (SMEs) provide the greatest number of jobs in
developing countries and are an important stimulus to national economies. However,
lending to SMEs is only a tiny part of private banks’ lending portfolio. Also, interest lending
rates charged to SMEs are often higher than those offered to larger firms because SMEs
are considered riskier. In Indonesia, total annual credit delivered to SMEs between 1998
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 78
and 2003 was never more than 21%. During this period, the credit offered to SMEs
increased after regional decentralization, allowing for regional governments to develop
their own lending policies.
Table: Credit delivery to SMEs compared to Total Bank Credit
Year Credit
delivered to
SMEs
Total
Delivery
Credit
Credit
delivered to
SMEs
Total
Delivery
Credit
Total (%)
(Million Rp.) (USD Million)
1998 43.870 487.426 5.223 58.027 9.00
1999 37.240 225.133 4.433 26.802 16.54
2000 55.840 269.000 6.648 32.024 20.76
2001 61.160 307.594 7.281 36.618 19.88
2002 60.840 365.410 7.243 43.501 16.65
March 2003 62.080 376.141 7.390 44.779 16.50
Source: Business Watch Indonesia, based on Monthly Report of Bank Indonesia, May 2003
In Indonesia, state banks, rather than private ones, most actively offer credit to the SME
sector. In March 2003, 55.4% of the total credit to SMEs was provided by the national
state banks, and 18.5% by regional state banks. Private banks provided 25.9% (down
from 29.8% in 1998) of the credit to SMEs in the same period.
This contrast between private and state banks lending practices vis-à-vis SMEs is often
not discussed in terms of the privatization of banks (see below).
3.2.2 The role of banks and the poor
The Indonesian case study research shows that only 14.3% of loans for small and
household handicrafts comes from banks with the rest coming from individuals, family and
money lenders.
Table: Source of main loans by SMEs and household handicrafts (1999, Million Rp.)
Bank Coope-
rative
Non-Bank
Financial
Institutio
n
Venture
Capital
Indi-
vidual
Family Others Total
Total
Enterprise
64,275 14,603 9,122 2,040 138,992 58,733 163,035 450,800
% 14.26 3.24 2.02 0.45 30.83 13.03 36.17 100
Source: Business Watch Indonesia, based on Statistic of Small Industry and Household Handicraft,
Central Bureau of Statistics or Badan Pusat Statistik (BPS), Jakarta - Indonesia, Year 1999
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 79
Few SMEs and household handicrafts take loans from banks because:
they are not interested or unwilling to use banks to get loans;
they lack collateral;
they do not know about or understand the procedures and are intimidated or
untrusting;
they do not meet the requirements.
Remember, many small companies exist within the informal economy and therefore are
not integrated in the Indonesian banking system. The advantage is that those in the
‘informal’ sector were protected from the financial crisis in 1997-98 because their assets
were not tied up in the banks.
Critical issues
To what extend can the banking system stimulate the alleviation of poverty
through SME loans? Or are other financing instruments are more efficient?
3.2.3 Foreign banks give little or no credit to poor
Foreign banks provided 0.005% of their total credit to SMEs in Indonesia in 2002 and
beginning 2003. This reflecting a downward trend as total SME credit by foreign banks
was 0.28% in 1998. Contrary to examples in Latin America and arguments from the
World Bank that claims that market opening increases efficiency, in practice there seems
to be nothing gained by SMEs in Indonesia.
Micro-credit organizations, established because national banks did not service the very
poor, provide very small loans to people, mostly women, without collateral. Formal banks
claim the costs to administer such loans are too high. The success of such examples of
Grameen banks is however a proof that the poor can be a good credit risk. The micro-
credit schemes in Indonesia are supported amongst others by the World Bank. Citigroup
is also supporting micro-credit NGOs through its Grameen Trust and it’s Community
Programme in Indonesia (Citibank Peka)
2
while its regular commercial financial services
focus on the big cities and richer Indonesians.
3.2.4 Neglecting poor regions
One of the problems with the financial industry is that they only set up in areas and
regions where the economy is already strong and where it can make profits. This means
that the majority of bank credit allocation is concentrated in the capital Jakarta and in the 5
biggest and most developed provinces. The area of Jakarta was still the biggest recipient
of credit in 2003 (39% of all credit in Indonesia), but the amount lent was about half of the
credit allocated to Jakarta in 1998. The credit to Jakarta in 2003 was still three times that
allocated to East Java, the second ranked recipient of bank credit.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 80
Table: Annual credit delivery (compared to overall national credit)
Province level
1
1998 1999 2000 2001 2002 2003 Change
’98-
DKI Jakarta 71.1% 60.7% 43.6% 39.1% 39.1% 38.73% -32.40%
East Java 7.5% 8.6% 14.0% 14.7% 13.4% 13.52% 6.06%
West Java 5.8% 8.3% 10.4% 11.1% 10,6% 10.12% 4.29%
Central Java 3.2% 4.7% 5.7% 6.9% 7.0% 6.76% 3.54%
North Sumatra 2.4% 3.2% 4.4% 4.7% 4.8% 5,20% n.a.
Source: Business Watch Indonesia, based on Monthly report of Bank Indonesia, May 2003
The figures do not show that foreign banks also establish operations and provide credit in
the regions that are the most economically advanced. Citigroup for instance, has eight
main offices in Jakarta and four throughout the rest of the country.
J
3.2.5 Increase in consumer credit rather than investment
credit
The BWI Indonesian case study indicates that between 2001 and June 2003, banks have
been focusing more on channeling credits to the consumer sector. Consumer credit has
increased 117% since the end of 2000 and held 22% of total credits by June 2003, up
from 14% of total credits, at the expense of credit for business investment.
Some banks allocate in total much more credit to the consumer sector than to the
investment sector. PT Bank Tabungan Negara, a state bank, gives 95 % of its credit to
consumer credits. The Bank of America operating in Indonesia only gives credit for
consumptive purposes.
Indonesian banks mostly give credits for business investment to those who have already
been running a business. So the proportion given for new investment is very small. Even
though encouraging consumption can stimulate economic growth, investment for business
is also crucial for the Indonesian economy to recover from the stagnation which resulted
from the 1997-98 financial crisis.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 81
Table: List of the banks with the largest consumption credits (June 2003)
Bank Credit Modal Kerja
(credit for working
capital/cash) (%)
Credit for
investment
(%)
Consumption
(%)
Status
1 PT Bank Rakyat
Indonesia
56.97 9.51 33.52 State bank
2 PT Bank Tabungan
Negara
4.61 0.25 95.14 State bank
3 PT Bank Danamon
Indonesia
45.23 22.63 32.13 bank taken
over
4 PT Bank Negara
Indonesia
50.62 35.13 14.25 State bank
5 Citibank N.A. 63.95 0 36.5 Foreign bank
6 PT Bank Central Asia 70.17 16.05 13.78 bank taken
over
7 PT Bank Permata Tbk 35.24 37.26 27.49 bank taken
over
8 PT Bank Mandiri 52.41 44.41 3.18 State bank
9 Bank International
Indonesia
28.40 46.91 24.69 Recapitalised
bank
10 PT Bank NISP 28.02 47.55 24.43 Recapitalised
bank
11 HSBC 74.67 10.62 14.71 Foreign bank
12 Standard Charterd
Bank
77.25 0 22.75 Foreign bank
13 ABN Amro Bank 82.51 0 17.49 Foreign bank
14 PT Lippo Bank 76.67 11.76 11.57 Recapitalised
bank
15 America Express
Bank Ltd
70.18 0 29.82 Foreign
16 Deutsch Bank AG 91.31 4.62 4.07 Foreign
17 The Bank of Tokyo-
Mitsubhisi Ltd
91.74 7.73 0.52 Foreign
18 The Chase
Manhattan Bank N.A
98.39 0 1.61 Foreign
19 Bank of America, N.A 0 0 100.00 Foreign
20 The Bangkok Bank
Corp. Ltd
79.15 20.73 0.13 Foreign
Source: Business Watch Indonesia, based on Investor Magazine Edition, Nr. 84, Year-V, 20 August
– 9 September 2003.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 82
3.3 Deregulation and the lack of regulatory and
supervisory capacity
Regulating financial services is complex and requires human and financial resources to
draft legislation, implement and enforce regulations. Deregulation and the relaxing of
banking rules in Indonesia, starting in 1988 and promoted by the IMF and World Bank,
made it easy to set up new banks. As a result, there was a great increase in new banks
and branches.
The 1997-98 financial crisis exposed the fact that many of the new banks were run by
businessmen with no banking knowledge or experience. To make matters worse, these
businessmen used the banks to finance their own businesses, violating lending limits
while manipulating the books.
With no supervisory authority intervening and so much corruption and bad governance,
some banks with bad loans were liquidated or restructured by the state that put money
into some of those banks that could be saved. The government paid out huge amounts of
cash, taxpayers' money, in the restructuring process, money that could have been better
spent on the many human, social and environmental costs of the crisis.
The financial sector restructuring process was supposed to be finished at the end of 2003
when the IMF program ended but new regulations and supervisory institutions were still
being debated in Parliament at that time. In the rush to complete the restructuring many
bad loans were liquidated with not enough compensation for the government's input.
The challenge is to ensure that the government does not provide more blanket guarantees
for bad loans and bad banking activities, that corruption is halted and banks remain
outside of politics. The financial sector’s institutional framework in Indonesia is still
unstable and creating the right framework is, politically and economically, difficult.
3.4 The critical roles of lending by foreign banks
3.4.1 The role of lending by foreign banks in the financial
crisis
The South East Asian crisis was not caused only by the corrupt system and lack of
regulatory and supervisory capacity in Thailand, South Korea and Indonesia, but also
because foreign banks lent credit in foreign currency. Some foreign banks did even not
have offices in these countries but they risked making short-term loans to banks and
companies in these South East Asian countries. They wanted to take a slice of the market
and they assumed the governments would intervene in case of problems. The domestic
banks and Indonesian business people also happily took loans from foreign banks at
much lower interest rates than from their domestic counterparts.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 83
However, once it became apparent that the reserves of foreign currency needed to repay
the short-term loans, were insufficient, the Thai currency crashed and each country
followed. The governments first took IMF loans to support the local currency and prevent
devaluation. Remember liberalizing capital flows and financial industry instruments leads
to capital flight and speculation in times of financial crisis, and the devaluation of local
currency against the foreign currency. Many of the loans from foreign banks were made in
foreign currency. When the local currency crashed, foreign currency became way too
expensive and default on loans in the foreign currency was inevitable. But the loan the
government took out to boost up the local currency had become more expensive to repay
after the devaluation, which meant that the government of Indonesia with a double burden
of loan repayment in foreign currency. It needed to pay for bailing out the private banks
as well as debt to the IMF, which means the Indonesian authorities had less to spend on
anti-poverty projects and improving their capacity to govern. At the same time, financial
and political restructuring to date, has not resolved many problems of corruption.
3.4.2 Odious governmental and private debt
Western governments and international governmental organizations, including
development banks and the IMF, alongside private banks were lending to the corrupt and
dictatorial Soeharto regime for years. Before the fall of Soeharto’s regime in 1996,
governmental debt was US$ 55.3 bn, of which $ 1 bn was due to private banks. After the
financial crisis and the collapse of the regime, Indonesia's official debt was US$ 77.9 bn
(2003) of which US$ 2.3 bn was due to commercial loans.
4
The Soeharto government had also raised money from private investors by issuing bonds.
The bond market is interesting to foreign institutional investors including pension funds
and mutual funds. By the time the Soeharto regime collapsed, most of the bonds issued in
the 1970-80s were repaid but new bonds issued had been issued in 1986 and 1996
(including the "Indonesian Yankee bond").
5
By September 2003, the total amount that the
government had to repay to bond investors was US$ 736 million.
In addition, the total external debt by Indonesia's private sector (banks, companies, etc.)
was around US$ 53.6 bn in September 2003.
6
At that time, external debt by Indonesian
private and state owned banks was estimated at $ 4.4 bn, part of which was owed to
foreign banks. Indonesian 'non-bank' financial companies had to pay an estimated $ 2.9
bn to foreign creditors. The private sector also issued securities that were bought by
foreign investors, totalling an estimated $ 1.3 bn in September 2003.
Civil society organizations have called for the cancellation of government debt after the
collapse of the corrupt Soeharto regime.
7
If there is no debt cancellation, the citizens and
the new regime will bear the debt burden and will have to repay loans, which were
unethical and very risky ('odious debt'). Corrupt regimes often misallocate loans and
cannot repay but civil society feels the lenders should bear the burden of this odious debt,
and not the population.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 84
Research shows that the foreign banks also make loans to corrupt companies, projects
and banks in Indonesia, which are risky and unethical. Full repayment of this private debt
could result in following through with projects that are very detrimental for the environment
and population, in order to generate the profits to make the repayments. The foreign
currency needed to repay the private debt also undermines an economic and monetary
policy that prioritizes domestic needs.
Total Indonesian governmental and private debt, and securities, that are due to foreign
creditors and foreign investors was estimated at $ 132.7 bn in September 2003 - higher
than the year before.
8
The private and governmental lending institutions do not agree with
cancelling or writing off governmental debt. The Paris Club, which is a forum where
governments and the international financial institutions negotiate the restructuring or
cancellation of the debt of developing countries, has discussed some rescheduling and
restructuring but not debt cancellation.
The foreign and international governmental institutions that are owned debt from
Indonesia belong to the Consultative Group of Indonesia. Negotiations on rescheduling
the government's debt from private banks have taken place at the London Club, a group
of international commercial banks. Members of the Consultative Group had pressured the
private sector to also reschedule private debt of Indonesia. In August 2002, the London
Club put forward an agreement with the Indonesian government to reschedule US$ 1.3 bn
in private debt.
9
The London Club's steering committee listening to the official arguments
included the five major creditor banks:
Bank of Tokyo-Mitsubishi,
BNP Paribas SA,
Commerzbank Aktiengesellschaft,
Hongkong and Shanghai Banking Corp. (HSBC), and
Mizuho Corporate Bank Ltd.
Eventually all the commercial banks involved in the private debt of the Indonesian
government had to give approval.
10
The London Club would however not reschedule the repayment of the "Indonesian
Yankee bond" because of a particular clause included in the conditions of the bond.
11
Orderly debt restructuring and equitable sharing of risks between issuers, underwriters
and investors of bonds has so far not been successful and there are no debt cancellation
instruments currently even available at the international level.
12
Civil society hardly monitors governmental debt to foreign bond owners and foreign banks
but the truth is, very little information is even transparent. Usually, creditor banks form a
consortium that negotiates with an indebted bank or company to restructure the terms of
repayment of the debt, aiming at the full repayment.
The Indonesian government's willingness to repay odious debt is due in part to its concern
about its credit rating. Standard & Poor and Moody’s grade countries for creditworthiness.
While debt rescheduling with the Paris club tends to upgrade a rating, rescheduling with
the private creditors more often leads to downgrades from the rating agencies.
13
The
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 85
lower the grades, the more the government and the private sector pay in interest rates to
banks for new loans.
At the beginning of 2004, investment banks were pushing the Indonesian government to
again issue $1 bn in new bonds. The government was reluctant to follow the advice,
preferring to err on the side of caution.
14
Both sides have clearly different interests at
stake: the government would increase its debt and probably decrease its spending to the
population or increase it in the long term, while the investment banks get income from
underwriting bonds but risk their reputation in case of default of repayment.
3.5 Private project and company financing carried over to
governments
The private financial industry has provided financing for Indonesian companies and
projects in the mining sector, the pulp and paper industry, and logging and palm oil
plantations. Corruption, environmental devastation and ensuing social upheaval, in each
of these sectors, have been rampant. The loss of old forests, species and biodiversity has
been increasingly documented.
Private banks, both domestic and foreign, and other financial firms have used different
instruments to finance these companies and projects, including:
15
syndicated loans for project lending,
bank credit facilities for activities and expanding a business,
securitization of loans, and,
underwriting new bonds and securities, and trading in project bonds and
securities.
The World Bank and ECAs, export credit agencies, have also provided financial support to
these devastating projects and corrupt companies. This financing from governmental
bodies has stimulated private financiers to join the financing of these Indonesian projects
or companies.
16
ECAs have been created to provide guaranteed credits and loans to Western companies
looking to send exports to developing countries. Now, they also provide guaranteed
investments to (exporting) companies in developing countries.
The guarantee of repayment, in case the investment or export goes wrong, is given to the
exporting companies as well as to banks that finance the exporting companies.
In other words, the governments, through taxpayers' money, assume the risks taken in
developing countries by the Western financial industry. In the case of Indonesia, many
ECA-guaranteed projects and exports went wrong, not only financially but also because
they turned out to be very destructive to the environment and harmful to the population.
The ECAs guaranteed that the Indonesian government had to repay the bad loans, which
increased Indonesia's governmental external debt by $ 17.5 bn!
17
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 86
What is an Export Credit Agency (ECA)?
An export credit agency provides government-backed export credits in the form of loans, and
guarantees or insurance for loans and investments. ECAs support exports and direct
investments in developing countries and emerging markets by corporations based in the ECA’s
home country. Usually overseen by the finance, trade, or economics ministry, an ECA uses
taxpayer money to make it cheaper and less risky for domestic corporations to export or invest
overseas. Some ECAs are privately owned but entrusted with handling credit guarantees of the
government. Almost all industrialized countries have at least one ECA. Like department stores
that provide credit so people without cash will buy the stores’ products, rich countries (through
their ECAs) provide loans and credit to developing countries, so that they will buy the rich
country’s exports.
Many ECAs offer direct loans, or, when commercial banks or exporters provide the loans or
credit, ECAs provide guarantees or insurance -essentially promises to reimburse the banks or
exporters and cover most losses. ECAs offer lower interest rates, premiums, and fees than the
private market would--and can also back transactions that the private market would refuse. But
for developing-country borrowers, ECA-backed loans are still at higher interest rates than many
loans from other official sources like the World Bank or the International Monetary Fund (IMF),
or other development banks and aid agencies. The results include debt for poor countries and
increased sales and foreign investment opportunities for multinational corporations based in
wealthy countries.
Few people recognize the scale and importance of ECAs’ role in the global economy. One ECA
enthusiast calls them “the unsung giants of international trade and finance.” In 2001, ECAs
covered $ 455 bn worth of business transactions with export credit insurance and $ 17 bn with
investment insurance. In comparison, the entire World Bank Group’s commitments in 2000
came to only $19.3 billion, and all official development assistance commitments from the global
North to the global South amounted to only $62.2 billion. Furthermore, despite recent
downturns related to the Asian financial crisis and September 11 attacks, export credits to
developing countries have been growing over the long term, while development assistance has
declined or remained stagnant.
Indeed, the increasing role of ECAs in the global economy -directly backing hundreds of billions
of dollars of international trade and investment and leveraging much more in purely private
flows- raises the question of the extent to which government intervention through ECAs has
actually driven the process of economic globalisation.
Not only are ECAs by far the single largest part of public financial flows from North to South,
but they are also the least examined, the least transparent, the least accountable, and, in some
ways, the most harmful.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 87
Among the issues critics of ECAs raise, are that they:
lack basic safeguards against environmental destruction, breach of human
rights, and corruption,
undercut governments’ developmental and environmental policies and
multilateral agreements,
contribute heavily to developing countries’ debt burdens,
have little or no transparency or accountability,
provide corporate welfare by passing business’ risks and losses on to
taxpayers,
contribute significantly to arms trade, expansion of nuclear power, and
global warming,
support destructive projects that even the World Bank would not touch.
Source: CIEL, Export credit agencies and the WTO, November 2003; Business Watch Indonesia
based on http://www.foodfirst.org/pubs/backgrdrs/2003/w03v9n1.html
Domestic banks, state owned and private ones, in Indonesia have been financing many
corrupt and destructive Indonesian companies. Some Indonesian banks were plagued
with corruption themselves. The Asian crisis in 1997-98 rendered loans to, and securities
of, these bad performing companies worthless. In order to avoid a total collapse of the
banking system and the wider economy, the government of Indonesia was forced, also by
its donors, to restructure domestic banks. The government assumed much of the bad debt
and created the Indonesian Bank Restructuring Agency (IBRA) to deal with restructuring
the debt and recuperating the assets related to the loans. However, the IBRA recuperated
much less than the amount of money invested by the government in recapitalizing failing
banks and assuming the bad debt. As a result, the reckless and corrupt lending by
domestic banks, sometimes financed by foreign banks, lead to a huge budget deficit.
State spending for recapitalization and debt restructuring has been at the expense of
spending to meet the social needs of the country.
3.6 Privatization
3.6.1 Privatization of the banking sector
Many banks in Indonesia have been inefficient, poorly managed and corrupt,
18
had low
profit margins, and offered bad service. They include under-performing state banks that
were supposed to ensure universal access and fair service for all citizens while at the
same time allocate money for the benefit of the development of the domestic economy in
situations where private banks don’t. This situation in Indonesia has parallels in other
developing countries.
In the case of Indonesia, it became clear after the financial crisis that the state banks were
recklessly run while foreign owned banks were more prudently managed.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 88
Table: Bank Categorization in Indonesia after the financial crisis (1999)
Groups of banks
Category A Category B Category C Total
State owned banks - - 7 7
National private banks 32 62 34 128
Take Over banks (BTO) - - 4 4
Local Govt. Dev. Banks 12 10 5 27
Mixed banks (Domestic and
foreign)
12 16 4 32
Foreign Banks 10 - - 10
Total 71 78 59 208
CAR: Capital Adequacy Ratio or bank health indicator
Category A: good business prospect; adequate capital reserves more than 4%
Category B: business prospect not good; adequate capital reserves less than 4% and more than -
25%
Category C: there is little business prospect; adequate capital reserves less than -25%.
Source: Business Watch Indonesia, Sector report, table 8.: based on information from Bank
Indonesia Annual Report, 1999
The IMF has pressed, as loan conditions, for the privatization of banks due to the poor
performance of these Indonesian state-run banks. The privatization of state banks was
done by finding investors for strategic alliances and by selling shares to the public.
However, shares and assets were sold at rock bottom prices, far below the amount of
money injected in these banks by the government before privatization. In the new strategic
alliances, the government often lost control over the privatized bank.
3.6.2 Financing privatization by the financial industry
The IMF, World Bank and donors have been arguing for the privatization of public services
including telecoms, postal, energy, health, education and water precisely because many
developing country public services are a mess and are hugely loss-making, offer poor
service, are inefficient and significantly contribute to budget deficits and rising debt.
The benefits of privatization are subject to hot debates. Proponents ignore
19
those cases
where prices have increased, distribution is more limited and excludes the poor, and
where governments loose control over resources needed to fulfil basic human rights
obligations such as universal health care and water distribution.
While the benefits and results of privatization are still debated in Indonesia,
20
private
financial firms have supported privatization by:
providing debt restructuring services
21
before the public services are offered for
sale,
giving advice to companies that want to buy the privatized companies,
providing loans to companies (often transnational corporations) that are buying up
the privatized public services, and
issuing shares and bonds
22
for privatized companies.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 89
3.7 Critical issues related to labour in the private financial
sector
In the context of poverty eradication, the financial industry could play a role in providing
jobs and good labour conditions. Indonesia's experience shows that the industry's
contribution might not be better than in other sectors while the presence of foreign banks
might make things worse.
3.7.1 Lay offs
Privatization and restructuring after the financial crisis led to massive lay offs. It is
estimated that in Indonesia around 5600 workers were made redundant when 16 banks
were liquidated in 1997. Given the low confidence in the banking system and the
economy, not many jobs were created afterwards.
3.7.2 Not respecting labour laws
In many industrialised countries the banking sector is a fair employer with relatively high
salaries and good-working conditions compared to many other sectors, but this is not
usually the case in developing countries. For example, Bank Negara Indonesia (BNI),
Indonesia’s second largest bank violated the regulations and law pertaining to ‘contract’
workers, which is common practice in Indonesia. Temporary contracts did not become
permanent contracts after three years, as required by law. Employees with temporary
contracts have no protection of their labour rights and an unclear status.
3.7.3 Discrimination between foreign and domestic
employees at foreign banks
There is evidence of discrimination between local and foreign employees when foreigners
move into management positions in developing countries. When Standard Chartered Bank
took over management of Bank Bali in Indonesia, wages and lifestyle of the expatriate
management was dramatically higher than for local staff, despite a worsening economic
situation of Bank Bali. In addition, discriminatory allocation of bonuses by Standard further
offended many domestic employees and managers of Bali Bank.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 90
3.8 Conclusions: critical issues for developing countries
The case study of the financial sector in Indonesia revealed some particular critical issues
of the financial services sector that are particular for developing countries:
1. Low financing levels for small and medium-sized enterprises, particularly by foreign
banks.
2. Reluctance by small or informal producers and the poor to take a loan from a bank.
3. Concentration of presence of national and foreign financial services in the
economically better developed regions and the political centres.
4. Changing focus of banks to consumer credit rather than credit for investments in the
economy.
5. The lack of regulatory and supervisory capacity, aggravated by corruption, has
resulted in huge amounts of bad loans being taken over by the authorities, and to the
restructuring of the financial sector; this has cost billions of dollars in taxpayers'
money that could not be spent on needs of the poor and the environment.
6. Lending by foreign banks to banks and companies in developing countries can be
large and be too risky, resulting in a financial crisis.
7. The Western financial industry is involved in the external debt of developing countries
through loans, underwriting governmental or company bonds and company shares.
While the debt owed by the Indonesian governmental to commercial banks and to
bondholders is far below debt owed to other (international) governmental
organisations, the external debt by the Indonesian private sector is relatively high
compared with the external debt by the government. Together, the huge external
governmental and private debt has an important influence on foreign exchange
management and economic development (e.g. focus on exports for foreign exchange
earnings rather than for domestic consumption).
8. Developing countries are dependent on Western credit rating agencies to obtain new
loans.
9. (Governmental) agencies that provide financial guarantees for trade with and
investment in developing countries protect foreign lenders and investors against non-
payment, while the financial burden is left with developing countries, further increasing
their external debt.
10. Privatization of national banks allow the domestic and foreign private financial industry
to take over the whole financial sector of the country. In this way, Indonesia becomes
part of the consolidation wave of the top world financial firms.
Critical Issues in the Financial Industry
Chapter 3 – The case of Indonesia 91
11. Financial firms provide several services to support and finance privatization of
essential services even if the benefits for the population is controversial and not
guaranteed.
12. There are different problems related to labour in the private financial industry:
Non-respect of labour laws.
Discrimination between domestic and foreign staff of a financial firm.
Corruption scandals result in (innocent) employees to be laid off to restructure the
troubled bank.
1
The financial sector study by Business Watch Indonesia (BWI) is published separately of this financial
sector report and contains much more details of the issues described in this summary. The sector and
country studies about the financial sector can be viewed in English on Somo's website www.somo.nl,
or a copy of the report can be requested from SOMO or Business Watch Indonesia (BWI). Information
and data mentioned in this chapter comes from the BWI case study except otherwise referred to.
2
http://www.citibank,com/indonesia/gcb/english/peka/index.html
J
www.citibank.com/indonesia/gcb/english/services/branch.html
4
Bank Indonesia, Public & private sector external debt, [November 2003], at www.bi.go.id
5
Bank Indonesia, Indonesian government bonds in international capital market, 7 November 2003, at
www.bi.go.id
6
Bank Indonesia, Public & private sector external debt, [November 2003], at www.bi.go.id
7
See by INFID: www.infid.org
8
Bank Indonesia, Public & private sector external debt, [November 2003], at www.bi.go.id: this amount
includes the figures mentioned in the paragraphs above.
9
Indonesia credit rating upgrade "imminent", S&P says, at www.bi.go.id/iie/news.asp?New=57
10
Indonesia credit rating upgrade "imminent", S&P says, at www.bi.go.id/iie/news.asp?New=57
11
Japan Credit Agency, Indonesia's Official External Debt Rescheduling Agreed, April 15, 2002 (viewed a
thttp://www.jcr.co.jp/topics/indoe.htm : 'at the London Club… the Yankee bonds due 2006 will not be
included in the debts to be restructured under "comparability of treatment" provision in the agreement."
12
Government gearing up for London Club meeting, in The Jakarta Post, 16 april 2002, view at
http://www.nafed.go.Id/news/Index.php:artc=16J
1J
Indonesia credit rating upgrade "imminent", S&P says, at www.bi.go.id/iie/news.asp?New=57;
Government gearing up for London Club meeting, in The Jakarta Post, 16 april 2002, view at
http://www.nafed.go.Id/news/Index.php:artc=16J
14
S. Donnan, Jakarta set to appoint banks for bond issue, in FT, 19 January 2004.
15
For further explanation, see chapter 1.
16
I. Altmeier, F. Irawan, S. Fried, R. Noor, Summary: Double destruction - The role of ECAs in
Indonesia's forests: from pulping the people to looting for palm oil while destroying US jobs, May 2002,
at www.eca-watch.org/problems/
17
Bank Indonesia, Public & private sector external debt, [November 2003], at www.bi.go.id: estimates for
September 2003; the ECA debt was US$ 16.9 bn in June 2003.
18
Business Watch Indonesia, sector study, chapter 1.3.2.: in Indonesia, some of the banks were owned
by the former president Soeharto's family such as Bank Andromeda, Bank Industry and Bank Jakarta.
19
See for instance examples of problems in many developing countries reported in Social watch report
2003 - The poor and the market, Uruguay, 2003.
20
NGO warns of unrestrained privatisation of public service, in The Jakarta Post, 14 February 2003.
21
See the case study of ING Group in Indonesia at www.somo.nl
22
Business Watch Indonesia, sector study, chapter 1.3.2.: underwriting by international investment banks
for telecommunication company Indostat and State Gas Company
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 92
Chapter 4
Corporate Social Responsibility
initiatives in the financial services
sector
Introduction
The private financial sector has an important role in discussions about corporate social
responsibility (CSR) and corporate accountability. By intermediating financial flows, many
financial firms raise, allocate and price capital as well as provide risk coverage for
businesses.
Increasing attention of the role banks play in business operations or large projects that
lead to human rights violations and environmental degradation has helped to open the
discussion of ‘accountability’ of these financial firms. The private financial sector, however,
includes a diverse group of sub-sectors, ranging from commercial and investment banks,
asset management institutions, reinsurance and direct insurance groups.
Apart from overall CSR initiatives covering all corporations in all sectors of the economy,
there are many specific initiatives that aim at setting voluntary CSR standards for the
financial sector. Some of these CSR initiatives cover all the activities within the financial
services sector, while others relate to some particular sub-sector financial activities such
as insurance.
Most of these private sector specific CSR initiatives can be divided into three areas:
1. How financial firms operate in-house: the social and environmental aspects of their
own operations such as labour and work conditions, recycling and energy
consumption.
2. How policies, services and products of financial firms impact society: the social,
human rights and environmental impacts of, for instance, projects financed by banks
or bonds issued by an investment bank. CSR initiatives relating to the impact of
financial services can also cover the way in which financial firms operate, e.g. the
terms an insurer uses to assess the risk of a company. These initiatives often focus
on how CSR principles are managed (not what their actual effects are).
3. How financial firms actively promote sustainable development: financial firms can be
pro-active and support socially and environmentally friendly developments, e.g. by
designing new products that favour better social or environmental practices. Such
products might be, for example, loans with lower interest rates for companies with a
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 93
proven social and environmental record. Financial firms can also advocate for more
sustainable practices among their colleagues within the whole financial industry.
This report does not include a fourth area, charitable initiatives by financial firms. SOMO
views that charitable activities would not be necessary if CSR would cover the core
business of any company and if all firms paid enough taxes.
Once CSR initiatives are underway and guidelines determined, reporting by financial
firms on the social, environmental and/or sustainable development aspects of their
activities and the implementation of the CSR principles to which they subscribe, is
necessary. Reporting initiatives of financial firms are described at the end of this chapter.
They reveal that most do not disclose the concrete social and environmental impacts of
their financing activities, but rather promote in-house policies and new ‘sustainable’
products, which makes evaluating the effectiveness of many financial CSR initiatives
impossible. Full reporting could however take CSR a step further to full implementation
and external verification.
This report does not assess the many different codes of conduct, business principles or
mission statements made by the different banks themselves. Neither will this report review
all the national initiatives underway, for instance by branch organizations of the financial
industry.
This chapter gives an overview of CSR initiatives at the international level that are
specific to the financial sector. This chapter is divided per sub-sector in the financial
services industry (for definitions see chapters above) but starts with those CSR initiatives
relating to all financial services.
4.1 CSR initiatives and guidelines covering all financial
services
There have been several international efforts to draw up CSR guidelines that would apply
to all activities of the financial services industry. In practice, guidelines are voluntary and
only apply to those in the industry that signed up to such initiatives.
Important allfinanz CSR initiatives, sponsored by only part of the financial industry, are the
EPI-finance project, the UNEP Statement by Financial Institutions on the Environment and
Sustainable Development, a statement by CEO’s of financial firms belonging to the World
Business Council on Sustainable Development (WBCSD) and The United Nations’ Global
Compact’s supplement on the financial sector.
In 2003, NGOs drew up The Collevecchio Declaration, which proposes a radically different
approach to corporate social responsibility in the financial sector than earlier industry
driven CSR initiatives.
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 94
4.1.1 UNEP Finance Initiative
1
From 1992 onwards, the United Nations Environment Program started to engage financial
firms and institutions in a dialogue on economic development, environmental protection
and sustainable development, through its Finance Initiative
2
(UNEP FI).
The mission of UNEP FI is to work with financial companies and institutions to identify,
define and promote good and best environmental practice in their internal and external
operations.
UNEP FI is a collaboration of more than 200 commercial and investment banks, insurance
and re-insurance companies, fund managers, multilateral development banks and venture
capital funds. UNEP does not manage the project and does not hold the budget. NGOs
are not the main partners of the initiative. NGO involvement has been permitted
occasionally, usually after letters of protest.
UNEP FI originally included two distinct parts: (a) the Financial Institutions Initiative and
(b) the Insurance Industry Initiative. Each of these initiatives is based on a related
statement of commitment to sound environmental and sustainability management
principles. (for the Insurance initiative and statement, see below).
The two initiatives were merged to become the UNEP Finance Initiative during the UNEP
FI Annual General Meeting in October 2003. Participants of the initiative still sign either of
the statements, depending on their core activities.
The “UNEP Statement by Financial Institutions on the Environment and Sustainable
Development”
3
This statement was established in 1992 and revised in May 1997 to include other financial
institutions than just banks. It focuses on the commitment of financial enterprises on
environmental sustainability in the three areas of their activities.
Internal operations, including energy consumption, resource efficiency and
waste recycling. These issues are frequently used to gain support from the
company’s management and to ‘green’ the office culture, because some gains
can be shown through cost reduction.
The Statement emphasizes that identifying and quantifying environmental
risk should be part of the normal process of risk assessment and management. It
supports the precautionary approach to environmental management.
The Statement promotes the development of products and services that will
actively promote environmental protection.
The Statement intends to promote environmental responsibility in the financial sector. The
Statement recognises the need that signatories conduct internal reviews and measure
their activities against their environmental goals. It promotes information sharing with
customers and other stakeholders; research; dialogue with other financial corporations
and sharing best practice with them; and work with UNEP to review their success in
implementing the Statement.
In addition to the two statement, the UNEP FI has three key working groups:
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 95
1. Climate Change: experts of banks and insurance companies join in this group to
assess the role finance can play in reducing greenhouse gas emissions, and
promoting renewable energy and inform policymakers on their findings.
2. Investment: this program aims to provide a platform for sustainability of
investments by e.g. institutional investors, especially in emerging markets. The
working group has also designed sustainability indicators for capital markets.
3. Environmental Sustainability Management and Reporting (SMR): this
program offers guidelines and a discussion forum for SMR, and collaborates with
the Global Reporting Initiative (see later in this chapter) on environmental
performance indicators for the financial sector.
Each working group:
includes 15 to 20 companies,
is chaired by one or two of the companies,
aims at exchanging views, developing common approaches and facilitating better
understanding of environmental trends and their implications for financial services
In addition, UNEP FI currently has two projects:
1. Finance and Conflict: this project attempts to analyse the role financial
companies have in sustaining conflicts, and consequently seeks to asses in what
ways financial enterprises can help promoting peace instead of conflict
4
.
2. Water: this project focuses on the role financial institutions could have in creating
water sustainability. It aims to assess potential risks and opportunities of
engagement in the water sector and water related domains.
Besides these thematical groups, the UNEP FI also has established five regional task
forces: Africa, Asia-Pacific, Latin America, North America and Central and Eastern
Europe. Those regional groups are supposed to work closely together with the general
working groups and projects.
Mostly through annual meetings, UNEP FI aims to stimulate discussions among
decision-makers and staff of financial firms around the world.
Critical issues
The UNEP Financial Initiative has some serious shortcomings. The statements
are not binding, and thus are no more than an expression of good intention. There
is no external verification mechanism of the implementation of the statement by
the signatory financial firms. According to observers, peer group pressure does
not take place as expected, which means that it is difficult to deal with the free
riders. Moreover, the commitments in the statement are not very far-reaching nor
strongly worded, which casts doubts about the meaningfulness and impact of the
statement
5
.
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 96
4.1.2 The EPI-Finance 2000 initiative to develop
environmental measurement indicators
In 1999 and 2000, 11 financial corporations with headquarters in Germany and
Switzerland developed indicators to measure the environmental performance of financial
firms.
The set of Environmental Performance Indicators for the financial industry (EPI-Finance
2000
6
) applied the new environmental performance evaluation standard of the
International Standards Organization (the so-called “ISO 14031”) 14031 as a guideline.
The EPI indicators are categorized by ‘Management Performance Indicators’ and
‘Operational Performance Indicators,’ and focus on primarily on direct environmental
effects of financial firm’s behaviour. The project did not consider ‘Environmental Condition
Indicators’ indicators that measure more indirect environmental impacts, for instance
associated with a project’s credit line. The financial firms developing the indicators
decided it is methodologically problematic to measure such environmental changes
because they see it as their client’s primary responsibility to document these changes.
7
The EPI-Finance 2000 proposes indicators covering four categories of financial services:
1. commercial banking,
2. investment banking (which here also covers project financing),
3. asset management,
4. insurance.
And indicators relating to:
integrating environmental issues into the core business, including operational activities,
development of environmental products and services for financing or insuring
environmental pioneers and innovations.
Because financial institutions rarely know their clients’ eco-balance, the guideline drafters
decided it was not possible in 2000 to develop universal indicators for environmentally
oriented products and services. Rather, each financial firm should define, for itself, an
environmental quality standard, which it is supposed to use to determine environmentally
oriented products and services.
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 97
The EPI-Finance 2000 report identified the environmental relevance of financial services
8
as described in the table below.
Table: The environmental relevance of financial services
Business sector Product and services with
particular environmental
relevance
Products and services with
less environmental relevance
Commercial Banking Corporate clients
Mortgage lending
Letter of credit
Guarantees
Lombard loan
Interbank business
Investment Banking Corporate Finance
Project Finance
Trade Finance
Trading
Asset Management Shares
Funds
Real estate (provided that it is
contained in “Assets under
Management”)
Money market
Interbank business
Insurance Corporate clients
(Environmental-) third party
liability
Life insurance
Source: EPI-Finance 2000, Environmental performance indicators for the financial industry.
4.1.3 WBCSD Working Group Finance
In 2001, the World Business Council on Sustainable Development (WBCSD) was
approached by a group of banks, insurance, and reinsurance companies and asked to
start a project on:
the impact of sustainable development on the financial industry,
the criteria on which a sustainability strategy for the financial industry should be
based.
Based on a series of stakeholder dialogues, the Financial Sector Project released a
position paper
9
in Johannesburg during the World Summit on Sustainable Development at
an event organized with the UNEP Finance Initiative (2 September 2002). The chairmen
of 11 financial firms that were member of the WBCSD Financial Sector Project:
argued that integrating sustainable development into their businesses is crucial for
continued success,
outlined the major issues from a business perspective, namely integrating sustainable
development into the core business and management systems as well as in relationships
with different stakeholders; promoting sustainable development issues with other
companies in the financial sector; creating innovative financial products and services that
promote a sustainable society,
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 98
recognised the influence and responsibility of financial companies as drivers for change
towards sustainable development in the sector, however it was noted that the limits of this
influence needed to be further explored,
encouraged the sector to be more transparent in its financial reporting.
4.1.4 UN ‘The Global Compact’ Financial Institutions’
Initiative
The UN Global Compact is a CSR initiative applicable to all business sectors, expressed
in 10 voluntary principles on human rights, labour rights, environment and anti-corruption.
The initiative was started by Kofi Annan, Secretary General of the UN, in an attempt to
integrate social and environmental issues in business practices.
In the beginning of 2004 financial institutions in particular were invited to join the initiative,
and in June of that year 18 financial institutions (among which banks, insurance
companies and asset managers) designed a set of recommendations and guidelines
especially directed to the financial sector, published in the report “Who cares who wins.
Connecting Financial Markets to a Changing World”.
10
In the report, the financial firms made recommendations to all sorts of financial market
participants, ranging from stock exchanges, pension funds, investors, financial advisors,
financial institutions and regulators. The main recommendations are:
Analysts, asset managers, brokers, investors and pension funds are
recommended to screen investments on Environmental, Social and Governance
(ESG) factors and urge companies to pay more attention to these issues.
Financial institutions are recommended to include these ESG indicators more
systematically in their research and investment decisions.
Companies should themselves also pay more attention to these issues in their
business activities.
Consultants and financial advisors are recommended to create more demand for
research on ESG performance, and work on improvement of reporting on those
issues.
Regulators should provide a clear, predictable regulatory framework. A minimum
degree of disclosure on ESG issues is necessary to improve the financial
analysis. Stock exchanges are recommended to require listed companies to
disclose information on ESG issues.
Accountants should facilitate standardisation.
NGO’s can play a role in providing the public and financial sector with objective
information on companies’ performance.
4.1.5 Wolfsberg principles
The Wolfsberg Principles
11
are a set of guidelines to combat money-laundering activities.
The guidelines were designed and endorsed by a group of 12 commercial banks, the
“Wolfsberg group”, called after a gathering at the Swiss Chateau Wolfsberg in 2000.
Members of the Wolfsberg group are: ABN Amro, Santander Central Hispano, Bank of
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Tokyo-Mitsubishi, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs,
HSBC, JP Morgan Chase, Société Générale and UBS.
The group has developed the following statements and guidelines:
Wolfsberg Anti-Money Laundering Principles for Private Banking (published in
October 2000, and revised in 2002). These principles state that banks will only
accept money of clients “whose source of wealth and funds can be reasonably
established to be legitimate”.
12
Statement on the Suppression of the Financing of Terrorism (January 2002).
Since not all funds to finance terrorism derive from criminal activity, regular Anti-
money laundering policies do not suffice to mitigate terrorism. The banks’ state
that they want to work with governments to prevent financial services to terrorist
groups, detect suspected terrorist financing, and share information with
government entities.
Wolfsberg Anti-Money Laundering Principles for Correspondent Banking
(November 2002). Corresponding banking refers to the services offered by a
domestic banks, e.g. a bank account, to foreign institutions. For example, the
Principles state more attention is to be paid to the correspondent banking client’s
domicile, ownership and management structures and business and customer
base.
Statement on Monitoring, Screening and Searching (published in September
2003). In this document, the Wolfsberg Group aims to identify means to
adequately monitor, screen and search financing of terrorist and other criminal
activities.
4.1.6 The Collevecchio Declaration by NGOs
A group of NGOs concerned with the damaging environmental and social results of
projects financed by banks and other financial firms drew up new guidelines and principles
for the financial sector.
The Collevecchio Declaration on Financial Institutions and Sustainability constitutes the
most comprehensive set of guidelines of the CSR initiatives up to 2003. The declaration
outlines civil society's expectations from the financial sector to advance sustainability.
These expectations go far beyond current practice and are radically different from the
financial industry’s current thinking, practice and CSR initiatives. The Declaration aims for
real improvements on the impact financial services activities have on societies and
environment.
The declaration was released
13
in January 2003 and was endorsed by over 100 civil
society groups by the beginning 2004.
The Collevecchio Declaration states the six key guiding principles NGOs are calling on
banks and other financial firms to adopt. It also outlines the immediate steps necessary to
implement the principles. NGOs expect financial firms to adhere to these six major
principles, throughout all levels of their activities and transactions.
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Principle 1.
Commitment to sustainability at the level of core business
Steps to be taken immediately
Measure environmental and social impacts of the financial firm's range of activities
including lending, investing, underwriting and advising.
Strive to continuously improve management and evaluation systems related to
environmental and social impacts of the activities financial firms finance.
Foster sustainability operations and products, transfer financial support away from
damaging activities to sustainable alternatives (e.g. renewable energy rather than
pipelines projects), and advocate sustainable practice within the wider financial industry.
Implement sustainability objectives and capacity building with and for staff.
Principle 2.
Commitment to adopt the precautionary principle and ‘Do No Harm’ approach
Steps to be taken immediately
Use sustainability procedures including project screens, which asses impacts at the
environmental and social levels.
Adopt internationally recognised sustainability standards relevant to the project or
company to which financial services are provided (e.g. Forest Stewardship Council
standards).
Principle 3.
Commitment to responsibility
Steps to be taken immediately
Bear full responsibility for the impacts of transactions and risks taken.
Recognise financial firms' role in developing country debt crises.
Principle 4.
Commitment to accountability to their stakeholders
Steps to be taken immediately
Engage in public consultation with the aim of taking the views of the stakeholders,
especially those affected by financial services, including when they say NO to a
transaction.
Support rules on stakeholder rights.
Principle 5.
Commitment to transparency
Steps to be taken immediately
Issue annual corporate sustainability reports with information pertaining to all levels of
business including sub-sectors and subsidiaries.
Disclose information on completed or pipeline transactions.
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Principle 6.
Commitment to Sustainable Markets and Governance
Steps to be taken immediately
Recognise and support the government’s role in policy and regulation.
Discourage inappropriate financial practices such as use of tax havens and currency
speculation whilst encouraging decisions based on longer-term time horizons.
The Collevecchio Declaration is being by used as a base for NGOs to assess and make
recommendations for other declarations, codes and CRS initiatives currently being put
forward by the financial industry (see below: Equator principles, reporting initiatives).
NGOs working with the Declaration meet regularly to update, develop and coordinate their
work under the umbrella named “BankTrack”.
14
NGOs are aware that not all improvements can come from the financial industry itself.
The Collevecchio Declaration (see principle 6) calls on the financial industry to support
regulatory changes that make it possible for the sector as whole, to advance sustainability.
This call warns against lobbying of the financial industry against governmental social and
environmental regulations for the financial industry, which could undermine CSR
initiatives.
Friends of the Earth-US issued recommendations aimed at improving regulation and
public policy.
15
4.1.7 Further developments and critical issues
Various CSR initiatives covering all financial services refer to continuous development
and changes of guidelines, and the need to improve transparency. Yet, most fail to call
for external verification.
So far, many initiatives focus on the environmental aspects of sustainability and corporate
social responsibility with less attention to social, labour and human aspects. While the
labour conditions in European banks might be fine, in developing countries, this is not
always the case even at branches of Western banks, as was revealed in case studies
researched by Observatório Social in Brazil
16
and Business Watch Indonesia
17
. Gender
issues should also be part of the corporate social responsibility because of the domination
of women employees at the lower job level and domination of men and masculine culture
at the (top) management levels.
The problems surrounding financial firms disclosing information on the implementation
of CRS initiatives has been the focus of many NGOs campaigns. Many banks refuse to
release information arguing client confidentiality and business competitiveness. However,
some ethical banks and even the Bank of Scotland release fairly extensive lists of projects
and clients, which shows that more transparency is possible.
18
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4.2 CSR aspects in retail and corporate banking
Banks' lending services to individuals, governments and companies have lead to many
civil society actions directed at particular banks
19
as well as the wider industry.
4.2.1 Project financing
Project financing is the target of many CSR initiatives. Projects that are considered ‘high
risk’ are precisely those where CSR problems are most likely to occur.
Risky project areas:
financing projects that harm tropical rainforests e.g. palm oil plantations,
financing mining operations,
financing oil and gas operations,
financing trade in 'blood diamonds' originating from rebels in conflict areas,
financing investments in countries that gravely violate Human Rights (e.g. Burma)
NGOs have undertaking campaigns against financial firms for their role in financing such
risky projects. In response, some financial firms have developed sector specific guidelines
for project financing. For example, ABN Amro developed the “ABN Amro Risk Policies on
Forestry and Tree Plantations". However independent, external verification of the
implementation of these guidelines is still not in place.
Various groups of NGOs are involved in developing environmental and social standards
for projects including dam and mining projects. They promote these standards at
international governmental sector forums such as the Forest Investment Forum and the
World Commission on Dams. These same standards should be used by the financial
industry in their risk assessments before financing these types of projects
20
and before
providing financial services to corporations in the related sectors. Project financing is a
small part of the activities of many large banks.
4.2.2 Equator Principles by banks
The Equator Principles
21
are a set of voluntary commitments, designed by a group of
banks, which are similar to those environmental and social safeguard policies already
being used by the International Finance Corporation (IFC), the private financing arm of the
World Bank.
The IFC convened a meeting of banks in London in October 2002 to discuss
environmental and social issues in project finance. At the meeting ABN Amro, Barclays,
Citigroup and Deutsche Bank decided to develop a banking industry framework to be used
to assess environmental and social risks in project financing. This led to the drafting of the
Equator Principles, which uses the IFC standards as a basis in lending procedures for big
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projects. Banks do not actually sign a statement. Instead, they ‘adopt’ the text and
promise to implement the framework in their organization.
By adopting the Equator Principles, the banks state that they will only provide loans
directly to projects if they have fulfilled certain conditions. Some conditions are:
Based on the safeguards of the IFC, the bank identifies the risk category of a
project: A, B and C. Categories A projects involve very risky projects, projects in
category B are less risky, and in category C projects, the risks are minimal or to
be neglected;
For all Category A and Category B projects, the banks have to complete an
Environmental Assessment (EA). The preparation of the EA is supposed to be
consistent with the outcome of the categorisation process and satisfactorily
address key environmental and social issues that have been identified during the
categorisation process;
For all category A projects, and for category B projects if applicable, borrowers
have to have prepared an ‘Environmental Management Plan’ (EMP) which draws
on the conclusions of the EA. It includes plans for mitigation, monitoring,
management of risk, and schedules.
If necessary, an independent environmental will be appointed for additional
monitoring and reporting;
Finally, the principles only apply to projects over $ 50 million dollar. According to
the Equator banks website
22
, projects below this threshold represent only 3% of
the total project finance market.
The banks that endorsed the Equator Principles in June 2003 were mostly those banks
which had been under pressure by civil society actions. The first 18 banks that signed the
Principles covered 74%, or $ 43 bn, of all project financing loans. In 2004, the Principles
are predicted by legal experts to become the prevailing standard for addressing social and
environmental issues in project finance transactions.
23
In the beginning of 2005, 28 banks
had endorsed the Principles.
Critical issues
No further steps?
Some banks confided with NGOs that in reality it is difficult to take further steps if
other banks do not also apply those principles. However, Citigroup agreed
beginning 2004 to implement higher environmental standards, for example,
related to endangered ecosystems and zones with social fragility, illegal logging,
climate change and renewable energy. Rainforest Action Network called
Citigroup's move the strongest articulated environmental policy of any private
financial institution.
24
Downgrading the IFC standards?
Just when the Equator Principles were finalized
25
(April 2003), the IFC
Ombudsman identified various implementation problems with IFC’s environmental
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and social safeguards. As a result, the IFC started an overall review of its
environmental and social safeguard policies and standards in 2004. NGOs
monitoring the process fear that the financial industry, which has been asked to
provide input, will push to weaken IFC policies. IFC is aiming to change its
principles ‘performance standards’ instead of ‘safeguard policies’. This could be
problematic, because then banks can will only try to satisfy the listed standards,
instead of actually trying to warrant the interests of stakeholders. If the IFC
standards will be weakened, this would also endanger the Equator Principles,
since they are the standards on which the Equator principles are based.
What difference in practice?
To date, it is not clear whether using these principles make a difference in practice
when banks screen new projects. Due to fierce international competition, banks
decide quickly about buying into a syndicated loan project. The extra times it
takes to assess sustainability aspects might result in competing banks stepping
into the lucrative project (although, if all banks adopted and abided by the
principles, they all must make the additional assessments).
Already during the early stage of implementation (January 2004) NGOs have
begun to question whether those banks, which signed up to the Equator
Principles even use them.
The principles seem not to prevent banks from financing the same kind of projects
that in the past have proven to be environmentally destructive.
26
Five projects have already been identified where signatories of the Principles are
financing
27
highly problematic projects, which violated IFC policies. The
controversial projects include the Baku Tbilisi Ceyhan pipeline
28
(ABN Amro is
coordinator of the syndicated loan) and the Camisea gas pipeline in Peru.
29
And for those projects that are ‘assessed’ using the Equator Principles, NGOs
have no way of verifying whether and how the banks actually implement the
procedures. Do they use models? Checklists? As there is no disclosure
mechanism, there is no way of verifying, at this point, how the principles are
implemented.
4.2.3 Beyond the Equator Principles
NGOs in BankTrack said that despite the problems, the Equator principles are an
important first step in reforming project finance.
In their first comment on the Equator Principles
30
(June 2003) BankTrack outlined
outstanding critical issues in the CSR debate:
1. No-go areas: The “Do no harm” principle in the Collevecchio Declaration calls for
an explicit commitment to categorical prohibitions for the most socially and
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environmentally egregious transactions. The Declaration also emphasizes a
precautionary-based approach rather than one based on mitigation.
2. Scope of applicability and effectiveness—too limited: NGOs recognise the
limitations of the current CSR initiatives in the financial sector as they mostly
apply to project finance only, and only pertain to direct loans. Banks should
review the environmental and social impacts of different segments of their
activities and develop appropriate policies. For example, mining and forestry are
often very sensitive sectors but are not commonly financed by project financing
and syndicated loans but for instance through open account credit to mining or
forest companies.
3. Lack of accountability and transparency: There is no mechanism for ensuring that
endorsing banks actually implement CSR standards. Banks refer to their
commercial interest to retain “bank secrecy” and refuse to provide civil society
organisations with insight in which projects they are financing or which companies
they financially support. It would be relatively easy for banks to disclose all of their
investments and projects, so that NGOs can independently monitor and scrutinize
projects. The lack of transparency requirements prevents endorsing banks to use
peer pressure and prevents the public to monitor implementation of CSR.
4. Weak on social issues: the standards of the International Finance Corporation
(IFC) are, compared with those of the World Bank, relatively weak on social
issues, and the Equator Principles reflect this weakness. For example the late
January 2003 version of the Equator Principles referenced “human rights,” but
was replaced by “socially responsible” in subsequent versions.
5. IFC standards are not best practice: NGOs hope that the adoption of the Equator
Principles will not delay the adoption of best practice sector standards such as
the World Commission on Dams guidelines, the forests policies proposed by
WWF-Friends of the Earth
31
, and the categorical prohibitions used by some
export credit agencies such as the U.S. Overseas Private Investment
Corporation.
6. Recourse and responsibility: The Principles put most of the responsibility on the
borrower, and there is currently no mechanism for affected communities to have
recourse to the bank in cases where standards are not being met or
implemented. In contrast, the IFC itself has a Compliance Advisor Ombudsman,
which investigates complaints from affected communities affected on alleged non-
compliance with IFC’s own policies.
Due to the many concerns about the implementation of the Equator Principles, in January
2004 BankTrack put forward a detailed statement
32
on precisely how banks should
implement the Equator Principles (EP).
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 106
Five sets of recommendations on how to implement and expand the Principles are related
to:
The full integration and implementation of the EP in the banks' operation,
including making themselves assessments of the social and environmental
impacts.
Integration of the EP in the banks' relations and agreements with borrowers.
Commitment to transparency and external verification.
Commitment to independent accountability mechanisms.
Commitment to move beyond the current scope of the principles and meet best
practices.
Ideally, other institutions including rating agencies, institutional investors and pension
funds, should use the Equator Principles when they have to assess a bank or other
financial firms.
4.2.4 Integration of environmental and social aspects in
regular corporate financing
Most banks take no consideration for social and environmental factors when providing
loans and financial services. Environmental factors are mostly only taken into account if
they affect the client's credit-worthiness.
33
If the client takes environmental risks, like
damaging the soil through the production processes, the bank might be affected. In this
scenario, the property, which is used as collateral is being partially or wholly devalued if
the production process damages the environment. Moreover, an environmental scandal
can affect the bank's reputation.
Some retail and corporate banks have begun taking a pro-active approach to promote
sustainability by offering environmentally oriented products such as 'eco-loans' that
provide favourable conditions for environmental pioneering or innovating projects.
4.2.5 Retail banking
Some ethical banks have special saving products that promote sustainable development.
For instance, clients can let the interest paid on their savings account be transferred to
environmental or development NGOs.
Until now, in CSR debates, little attention has been paid to the social role banks perform in
society, and as a consequence their responsibilities in providing services to a broader
public.
There do exist some good initiatives of banks that acknowledge their social role, and have
as a consequence taken steps to improve access to credit:
Some banks have committed themselves to keeping branches open outside of
urban areas, to support to the elderly and the rural population.
34
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 107
The importance promotion of credits to SME’s has also been identified and
followed up by some important institutions. For example, the European Bank for
Reconstruction and Development (EBRD) has a special program to stimulate
finance to SME’s in East European countries.
35
Increasingly, some mainstream banks have set up micro-financing activities . For
example, ABN Amro did so in Brazil in 2003 and Citigroup financially supports
micro-credit schemes in Indonesia. With micro-credit, small entrepreneurs are
provided with very small credits, which is generally believed to be a very good
mechanism to combat poverty. The UN have designated 2005 the “International
Year of Microcredit”, a project coordinated by the United Nations Capital
Development Fund (UNCDF) and the United Nations Department of Economic
and Social Affairs (UNDRSA). The project is sponsored by Citigroup, ING Group
and Visa.
36
4.2.6 Alternatives
Even thought banks have paid increased attention to CSR issues, too often these
initiatives are used as mere Public Relations and charity, and are not considered as
banks’ core credit activities. Some civil society groups have therefore developed ideas on
ways to arrange credits, without reliance on the commercial banking sector. The credit
unions already present in many countries, are an example of such an alternative to
commercial banks. Some NGO’s have proposed more far-reaching systems. For example,
the Strohalm Foundation stimulates the use of Local Exchange Trading Systems (LETS)
in which small companies and consumers cooperate. The profit of such systems is that
people are less dependant on a bank, and that there they don’t have to pay any interest.
37
4.3 Asset management and socially responsible
investment
Different financial service providers are involved in asset management:
Banks and investment firms assist corporations, wealthy individuals and
institutional investors by managing their capital and other assets to get the
highest rate of return.
Insurance companies manage assets in order to have enough financial reserves
to service potential insurance claims.
Pension fund managers invest to increase their capital to guarantee payment to
pensioners who paid contributions.
Mutual funds invest in company shares to increase the value of their funds and
provide high returns to their clients.
An important part of asset management (managing money) is buying equities that are
expected to earn high returns in the short or long term. These investments allow
companies listed on the stock market to operate and expand their activities.
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4.3.1 Investing in companies - socially responsible
investment (SRI)
Asset managers have traditionally only focus on high returns when they select a company
to invest in. Rarely, if ever, did they use criteria beyond those which assess the financial
viability and profitability of companies. Their investments could, and do, support
companies whose activities are exploitative, destroy the environment and violate human
rights.
Due to many actions, discussions and initiatives by civil society groups and trade unions
there has been increased pressure asset managing institutions, including pension and
mutual funds, to review the corporate social responsibility of companies in which they
invest and withdraw their capital from companies which violate human rights and destroy
the environment.
Different strategies can be used to screen companies on social and environmental
criteria
38
:
Exclusion mechanism: certain sectors/companies will simply be excluded from the
investment portfolio (e.g. nuclear energy, weapon industry, tobacco,
pornography);
Targeted investments: investments will be specifically directed towards
sectors/companies/projects that have a social value added (e.g. education,
recycling, healthcare, renewable energy);
Best-of-class approach: investments will be directed towards companies that are
performing well on social and environmental issues compared to other companies
in the same sector;
Engagement: investors will use their shareholder power to engage companies
into better social and environmental policies.
As a consequence to this increased attention to socially responsible investments, a large
industry has evolved around the research of and ranking of companies on SRI grounds.
Since research on environmental and social performance can be costly for individual
investors, these firms make it easier for asset managers, institutional investors a means to
include these indicators in their choice of investments.
Research institutes include SiRi company, an international network of private research
organizations. These institutes often also establish rankings of companies.
Other SRI research include ‘sustainability rankings’ like the Dow Jones Sustainability
Indexes
39
(e.g. the Dow Jones Sustainability World Index) and the FTSE4Good Index
Series
40
.
SiRi
The Sustainable Investment Research International Group, (SiRi) is an umbrella
organization for private research organizations in different countries, which supply
information to the largest asset managers, insurance companies, pension funds, banks
and social investment institutions of the world.
41
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 109
The member organisation of SiRi in the Netherlands is the 'Dutch Sustainability Research
BV' created by Triodos Bank, PGGM (pension fund), and MeesPierson (a private banking
branch of Fortis). It cooperates with Triodos Advisory Services BV.
The SiRi database contains profiles of 600 large international companies and 4 000
other companies worldwide.
42
SiRi claims that each profile contains over 350 data
points and analysis, and "that all major stakeholder issues are covered including
community involvement, environmental impact, employment relations, customer policies,
human rights issues and corporate governance.” For each issue, SiRi describes and
analyses the company's policies, management systems, reporting standards and impacts
together with particular strengths and weaknesses. In addition, SiRi Global Profiles
contain information on controversial business practices such as armaments, tobacco,
animal testing or GMOs. "These profiles allow comparison between companies, sectors
and markets over the whole range of socially responsible investment issues of concern to
professional investors."
43
4.3.2 Mutual funds and ethical funds: is there a difference?
To date, SRI information is not often used by mainstream investment and mutual funds
managers. Instead, this information is especially used by “ethical funds” that buy up
shares from companies that are screened for their records on environmental and social
responsibility.
Either by using external research, or their own, ethical funds in Anglo-Saxon countries
tend to exclude weapons and tobacco companies immediately. European ones tend to
seek out companies that play an innovative role on providing a substantial contribution to
corporate responsibility or sustainable development.
SiRi's overview
44
showed that as of June 2004, there were 354 European green, social
and ethical funds, or 13% more than in the 12 months prior. SRI assets dropped by 16%
from €14.4 billion at the end of 2001 to €12.2 billion at the end of the second quarter 2003.
In 2004, assets under management accounted for €19 billion.
The shares of companies that are most often included in European green, social and
ethical funds are Vodafone, Pfizer, Johnson & Johnson, Citigroup, GlaxoSmithKline,
Microsoft, Royal Dutch Petroleum (Shell), Astrazeneca, BP and Nokia. However, several
of these companies have been the target of civil society initiatives due to their
irresponsible and destructive activities. Ethical, social or green funds seem to often
include companies which are subject to NGO protests.
45
For instance, the 'ING Bank
Duurzaam Rendement Fonds' includes Royal Dutch Petroleum (Shell), American Express,
Bank of America, Johnson and Johnson, BP, McGraw-Hill Companies, Suncor Energy,
Medtronic, Bristol Myers Squib, Societé Générale. Independent research has criticized
ING’s investment criteria.
46
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 110
Critical issues
No official mechanism exist to decide whether it is appropriate for SRI to include
transnational corporations as ‘ethical’ whose activities to date are known to cause
social and environmental destruction while thwarting corporate social
responsibilities.
SRI research institutes, to date, only focus on large companies listed on the Stock
Exchange. Do ethical fund managers have the capacity to identify small
sustainable companies that are not listed on the stock exchange? More analysis
should assess the difference of selection between ethical funds from large banks
and those funds from alternative banks such as Triodos Bank.
4.3.3 UN norms for responsible investments for institutional
investors
In the context of UNEP FI’s asset management working group, in 2004 UNEP FI
announced their "Responsible Investment Initiative", as part of UN’s Global Compact
Initiative. In 2005, the UN will convene a group of leading institutional investors to draft a
set of Investment Principles, while a group of experts will provide advice. In 2006, the
plan is to build support and capacity from within the investor and policy-making
communities globally.
4.3.4 Pension fund management
Institutional investors and especially pension funds wield huge amounts of weight on the
capital and investment markets.
Civil society
47
, church groups and some trade unions increasingly have been pressuring
pension funds to invest in companies with high CSR standards, or in ethical and green
investment funds. In the UK, investment in SRI assets went from zero in 1997 to £ 80 bn
in 2001.
48
A 2003 report on the 250 largest UK occupational pension funds showed that
90% included social and environmental considerations in their Statement of Investment
Principles, however only 11% of the funds included either screening, a preference
approach or both in their socially responsible investment policies.
49
In the Netherlands,
still only 1% of total assets is directed to SRI portfolios.
50
One of main problems with pension funds is that the people who pay the contributions
(employees) and the people who receive the payments (pensioners) have no information
about how their pension is invested nor do they have any say in the matter. Banks and
other financial advisory companies have much more say in the management of the
pension funds’ assets. In other words there was, and still is, little stakeholder participation.
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 111
Another problem is that governmental regulation is focused on guaranteeing future
payments to all pensioners who paid contributions, not on ethical criteria. Such
governmental regulations can even undermine efforts to use ethical criteria. Pension funds
that withdraw their shares from exploitative companies might loose highly profitable
shares that help to meet the requested income for the future.
Critical issues
There is now a fierce debate by governments and firms that offer pension
insurance on how income to pensioners can be guaranteed. The right to a
pension is under threat because accumulated savings decrease in value due to
market downturns and mismanagement of private pension funds which has
shrunk the needed reserves. Because of this financial trouble of pension funds,
equity considerations and ethical and environmental criteria get even more in the
margin. Will Western pension rights prevail over progress towards sustainable
development?
4.4 Insurance and Corporate Social Responsibility
Insurance allows individuals and companies to undertake activities by providing financial
and other support in case of loss and damage. It allows individuals to rebuild their lives
after theft, fire and health problems and enable companies to engage in risky business
(i.e. transport) or pay for employees who are ill.
From a corporate social responsibility perspective, the questions are:
Which individuals, companies and activities does an insurance company support
by providing its products?
What are the effects of its operations and its products on human rights, the
environment, labour, consumers and society at large?
How do insurance companies manage their funds?
Do the insurance products promote sustainable development?
4.4.1 Responsibility on social aspects not yet developed
In conducting this research SOMO has found little evidence of international initiatives
focusing on the social responsibility of the insurance industry except those related to asset
management (see above). The insurance industry business owns and manages a huge
amount of assets in order to pay for potential claims for insured clients. Equities (company
shares), bonds, property, real estate, art and other valuable items are examples of various
insurance company assets.
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 112
Consumers’ rights, such as the right to be informed, are legislated in Western countries.
Insurance companies have broader social responsibilities however, related to human
rights, labour and consumers rights to access to basic services:
a. Universal access to basic services such as health insurance
Some basic principles of the International Covenant on Economic, Social and Cultural
Rights (CESCR) are non-discrimination and providing the highest standard of basic
needs. Private health insurance increases access to medical care and help reach the
highest possible standard of health care. On the other hand, private health insurance is
often only accessible to the rich. Companies offering private health insurance are
expanding in developing countries but some experiences such as in Kenya
51
show that
private health insurance companies focus on rich clients and deny poor clients their
services. If the rich opt for private health insurance, governments in developing countries
have less income to care for the remaining citizens who are mostly poor with no choice
but to stay with the government’s health care plan. This undermines the whole notion of
universal access and non-discrimination.
A socially responsible insurance strategy would mean adopting practices and activities
that avoid the exclusion of the poor and especially women, older people, disabled, ethnic
minorities and those in remote areas.
b. Labour
To date, there is little known about the working conditions of insurance employees, agents
and brokers in developing countries. It is also unknown whether employees are duly
informed when their insurance company is involved in mergers and acquisitions (see
OECD Guidelines, IV Art. 6).
There is no debate yet regarding whether insurance companies should assess a
company’s labour record prior to selling it insurance products.
c. Other ethical issues , as identified by the Global Reporting Initiative
52
(see 4.6)
Medical screening of clients and genetic testing: excluding clients based on their
medical record and sometimes genetic inheritance about which they have no
influence, undermines the very principle of insurance as a safety net for people
with unequal chances;
Transparent commissioning and handling of claims; in 2004-2005, the insurance
industry has been overshadowed by scandals whereby in the US it came to light
that many US insurance brokers and insurance companies were collectively
betraying customers by charging too high premiums. Insurance firms offered
brokers commissions that are only paid if the broker delivers a certain amount of
clients to the company. As a consequence brokers steered tenders so that clients
choose products from insurance companies giving the broker the highest
commissions.
Responsible marketing (best advice)
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 113
4.4.2 Environmental issues in CSR initiatives
The increasing number of claims from a damaged environment and from disasters due to
erratic weather patterns has alarmed the insurance industry and forced it to accept that
they must incorporate environmental considerations into their policies.
Risk is always the starting point for insurance companies and ‘the environment’ is still
looked at in many different ways.
Some insurance companies recognise that damage to the environment can result in the
insured person or company having to stop operations, which is a risk of loss of income.
For the insurance company, this might result in loosing that person or company’s premium
or even in having to pay out a claim.
Other insurance companies recognise the role of their own activities in supporting
sustainable development.
Some insurers go further to promote sustainable development through interaction with
other economic actors of the insurance industry and consumers.
Some insurance companies are starting initiatives to manage and reduce the risk of
adverse impacts on the environment ("environmental risk"
53
) such as contamination of
land, negligent of bad management of waters or hazardous facilities, and emissions that
increase climate change. The criteria and measures they use are:
1. Attention to environmental risks in core activities including:
1. Risk management: techniques to calculate risk and price insurance products, which
include environmental risks factors such as the use of chemicals, the location of the
insured industry, community acceptance, the risk of pollution.
2. Prevention of loss and damage:
Measures of loss prevention as condition for insurance coverage.
Clients are required to use environmental risk control methods.
3. How insurance claims are handled.
4. Design of insurance products:
Contract terms and conditions, such as lower insurance premiums for
environmentally positive behaviour by the insurer (e.g. If the car covered
by the insurance travels a low number of kilometres).
Pricing of insurance contracts based on environmental risk management
of the insured companies rather than categories of companies.
5. Support for environmentally positive operations: for example, insurance for the wind
power generation business, insurance covering bicycle breakdowns and train
delays.
54
2. Environmentally friendly management of internal operations, including energy,
water and paper usage, responsible travel and properties; related issues include the
training of employees and communication practices and reporting on environmental data.
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 114
3. Commitment to apply national and international environmental regulations.
On the other hand, some insurance companies provide insurance products for liability
arising from environmental damage such as pollution and compulsory clean up
operations.
55
This might encourage companies to continue to pollute even if they have to
pay an insurance policy fee.
4.4.3 UNEP Finance Initiative on insurance focuses on
environment
In 1995, various insurance, re-insurance companies and pension funds outlined a
"Statement of Environmental Commitment by the Insurance Industry"
56
By December
2003, the Statement was signed by 84 companies and 3 associations in 25 countries.
57
The signatories acknowledge the role they can play in managing and reducing
environmental risks and the skills their industry has to measure and respond to risks. On
the basis of this statement, the UNEP launched an Insurance Initiative to fund research
and organize awareness meetings and workshops.
In 2003 the initiative merged with the UNEP Financial Institutions Initiative, into the UNEP
Financial Initiative.
Similar to the UNEP Statement by Financial Institutions, insurance signatories want to
achieve sustainable development through the market within a regulatory framework and
accept the precautionary principle. They want governments to take the leadership in
defining and enforcing long term priorities “values”.
Through the statement, insurance companies commit themselves to pay attention to
environmental risks in their core activities. These activities include risk assessment of
potential clients, loss prevention, product design, claims handling and asset management.
Internal operations and property will be managed "in a manner, which reflect
environmental considerations". This is a weaker commitment than made by the Financial
Institutions on Environment and Sustainable Development.
The signatories promise to make periodic reviews of management practices and to
integrate changes in environmental management in core activities and in communication
with employees. They encourage researching creative solutions and claim to strive to
adopting best practices in environmental management within the industry and suppliers.
They promise to create measurable environmental goals and standards for undertaking
regular internal environmental reviews. Within the limits of “commercial confidence”,
relevant information will be shared with stakeholders.
4.4.4 Example of individual or branch CSR Initiatives
Besides the UNEP-FI insurance initiative, there is no major international CSR standard for
the insurance sector. Some individual insurance companies have been involved in smaller
initiatives. For example, some insurance companies are offering micro-insurance services
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 115
in developing countries. The Dutch Interpolis, for example, cooperates with local
organizations in developing countries like Sri Lanka and the Philippines to establish
mutual micro-insurance schemes. These small organizations are stimulated to become
self-sufficient in the future, so that the local community can help itself within their own
social structure
58
. In addition, often national insurance branch organisations have
developed their terms of reference for CSR policy.
4.5 Investment banking
Investment bankers are intermediaries between the issuer of securities and the investor,
as well as advisors to the company issuing the securities. Only a few examples of CSR
initiatives in investment banking could be identified for this research report. There are
however many ways by which investment bankers have an effect on sustainable
development or could actively promote it. For instance, by screening the social and
environmental record of companies and governments before deciding to underwrite their
new securities. There are no clear signs that banks use CSR criteria in their decision to
underwrite or in the prospectuses they publish to inform future investors.
Investment banks can be affected by the bad social and environmental practices of their
clients. By underwriting, a bank assumes the risk of buying all the new securities from the
issuer and reselling them to the public. A bad reputation from social and environmental
damages caused by the issuer could reduce the value of the new securities, and thus
provide a risk to the underwriter.
4.5.1 CSR issues from the Global Reporting Initiative
The Financial Services Sector Supplement on Social Performance Indicators of the Global
Reporting Initiative (GRI) (see 4.6) have identified the following CSR issues of investment
banking:
Debt of developing countries
Investment bankers issue debt instruments such as bonds for developing
countries. This can help raise money for developing countries but can also
increase the debt burden by these countries as they have to repay the bond with
a set (high) interest rate at a certain date. If the issuing is done while the country
is already in financial problems, the repayment might easily become problematic
and lead to a difficult process with bondholders to reschedule or write off this
debt. This has been the case in many developing countries.
Financial support for projects, companies or governments with considerable
critical social or environmental behaviour.
By underwriting securities unselectively, investment banks may continue or
increase the malpractices implemented by their clients.
Bribery and corruption, e.g. in order to obtain investment banking contracts.
Control over corporate governance of recipients of investment bank services.
Number of poor country clients.
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 116
Innovative products that apply special ethical and sustainability criteria.
4.5.2 Issuing bonds from the World Bank
Investment banks operate not only as underwriters for bonds by developing country
governments but also for financial institutions like the World Bank. The World Bank gets
80% of its funds for loans to developing countries from the selling of its bonds. Most of the
World Bank bonds are bought by institutional investors such as pension funds. The latter
are confident that there is little or no risk that World Bank will not repay the bonds because
of the governmental backing and high rating (AAA) of the World Bank.
World Bank loans to governments, with the money raised from the bonds, have been
made conditional on major macro-economic restructuring programmes. Many civil society
groups see these programmes as increasing poverty and undermining sustainable
development. Civil society groups from Haiti, South Africa, Ecuador and Europe have
campaigned to boycott the buying of World Bank bonds. In response, many civil society
groups world wide are encouraging citizens to request their pension funds and other asset
managers not to buy World Bank bonds.
59
4.5.3 Emissions trading
The UN Framework Convention on Climate Change, through the Kyoto Protocol,
introduced international emissions trading, a market mechanism whereby countries buy
and sell their ‘right’ to pollute based on a credit scheme.
Financial firms are involved in emission trading in various ways, partly because there is
money to be made but several firms also intend to offer new products that hedge against
the risks of emissions particularly in the derivatives market.
60
4.6 Reporting initiatives by financial institutions
Reporting on the above described initiatives so far remains at the firm level (do financial
firms recycle, turn the lights off?) and at the level of monitoring management (did financial
firms develop the criteria and if so, how are they managing the implementation?). This is a
serious problem for assessing the concrete impact of corporate social responsibility and
accountability of a financial firm.
Most information is kept secret due to ‘client confidentiality’ and ‘competition,’ which
means CRS and sustainability results are underreported. With so little information,
external monitoring and verification is impossible.
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 117
4.6.1 Social performance reporting through the GRI Financial
Services Sector Supplement
The Global Reporting Initiative (GRI) is a foundation that aims at offering companies a
framework for sustainability reporting. This set of guidelines is for voluntary use by
companies for reporting on the economic, environmental, and social dimensions of their
activities, products, and services. Companies of all different sectors are supposed to be
able to use the GRI guidelines. There is a central document for all sectors (“the
Guidelines”). Developed in a multi-stakeholder process, the general GRI guidelines intend
to be globally applicable with standardized reporting, which means comparing companies
will be possible.
In addition, GRI has developed “technical protocols” that help companies in implementing
the guidelines in practice. Finally, for some industry sectors GRI has developed specific
“sector supplements”. For the financial sector, a pilot version for a supplement for social
performance has been published in 2002.
In cooperation with UNEP-FI, GRI has also been working on a supplement for
environmental performance indicators for the financial services sector. This supplement
was published in March 2005 (see 4.6.2).
4.6.1.1 Social Performance indicators
The social performance indicators started as a pilot version
61
in 2002, and are ready to
use. They are based on an initiative already developed by a financial industry group, the
Social Performance Indicators initiative
62
(“SPI-Finance”).
The GRI Financial Services Sector Supplement on social performance contains
performance indicators as well as management performance indicators. The latter
describe the quality of engagement on corporate social responsibility (CSR Management).
The indicators are qualitative and quantitative, but take into account that quantitative
indicators will always need some qualitative interpretation.
The performance indicators for the financial services sector’s social impacts cover the
following areas:
1. Internal social performance, including relationships with staff's families.
Society in general, such as performance towards communities and countries in
which the business operates.
Impacts of products and services on clients, as well as on people who are
indirectly influenced by financial services.
The social performance of suppliers (towards their staff and society), as well as
performance of the financial firm towards those suppliers.
The management and operational performance indicators
63
for reporting are organized
under the following eight aspects:
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 118
Management Systems: management of sensitive issues in all financial operations such as
bribery and corruption and anti-money laundering.
Internal Performance: human resources policies towards equal opportunities (banks are
well known for employing many women in the lower paid jobs and few at the top), stress
and ergonomics (SRI syndrome policy due to frequent use of computers), remuneration
for senior management, and for achieving CSR criteria.
Suppliers: screening of major suppliers for their social performance.
Society: the economic value created by a company's activities and its contribution to GNP.
Retail Banking: avoidance of social exclusion through access to financial services,
innovative products and financing to deprived communities; lending with considerable
social impact; marketing practices (e.g. of speculative of highly indebting products).
Investment Banking: issuing of debt instruments for developing countries and other
aspects of developing countries' debt; financial support projects with considerable critical
social impacts; bribery and corruption; control over corporate governance of recipients;
number of poor country clients; innovative products that apply special ethical and
sustainability criteria
Asset Management: responsible marketing and advice; screening of portfolios against
social criteria; innovative products that apply special ethical and sustainability criteria
Insurance: medical screening of clients and genetic testing; transparent commissioning;
level of access by women, old(er) people, disabled people, ethnic minorities, and people
living in geographically remote or disadvantaged areas; innovative products with special
social benefit that are not yet offered by the market.
4.6.1.2 NGO criticism
A group of environmental NGOs that published the Collevecchio Declaration criticised the
GRI's Financial Services Sector Supplement on social performance because it was not
based on an extensive and transparent multi-stakeholder process. Southern NGOs were
not heard during the development of the indicators whilst the indicators were determined
by the involved financial firms. The Supplement “focuses too much on internal corporate
responsibility aspects”
64
while the product and client side are far more important.
Financial corporations have the responsibility for the environmental and social impacts of
the activities they finance even if this entails indirect or complex financing operations.
Additional missing indicators in the GRI's Financial Services Sector Supplement on
social performance from the perspective of SOMO’s research includes:
The social impact of developing countries' indebtedness to private financial firms
or to holders of bonds or other debt instruments issued by banks;
The lobbying and political activities of financial firms against rules that promote
environmentally and socially progressive financial products and operations; or the
lobby against measures that limit developing countries' or poor people's
indebtedness;
The lobbying activities of financial firms to open up markets in developing
countries (e.g. in current GATS negotiations of the WTO) without a commitment
to increase the social and environmental benefits of such market opening;
Financial operations and products that contribute systematically to economic or
financial crises at the national and international levels with huge social
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 119
consequences (job losses, etc.); examples are operations in speculative products,
quick moves out of a country for asset management purposes;
Providing services to clients to evade taxes such as presence in taxes havens,
which reduces governmental budgets to provide public social services;
The social impact of mergers, acquisitions and restructuring of companies, which
were advised and financed by private financial firms (mostly through investment
banking); at least investment banks could first evaluate if the companies involved
respect ILO Conventions and OECD guidelines for multinational enterprises
before offering their services (e.g. information to employees in due time before
mergers take place);
The link between social and environmental performance is absent
(environmentally damaging activities can have a direct social impact and vice
versa); the Supplement on social performance reporting indicators needs to be
integrated with environmental performance indicators (see below).
4.6.2 Environmental reporting indicators
4.6.2.1 Corporate initiatives
The set of environmental performance indicators for the overall financial industry
developed by the EPI-Finance 2000 project (see above) were primarily designed for
internal use and not for reporting, but they can serve as a basis for “external
communication”. The set calls, for instance, for concrete figures such as the number of
loans for projects that are environmentally pioneering or innovative. UNEP and the
WBCSD welcomed the set as a meaningful benchmark.
4.6.2.2 UNEP FI / GRI Initiative on environmental performance
Since September 2003, UNEP-FI and GRI have been building on the work completed in
the social arena, and worked to develop environmental performance indicators for GRI’s
financial sector supplement. A multi-stakeholder working group developed the indicators.
The working group had ten representatives from the financial industry, and ten
representatives of NGO’s and sustainability rating agencies. GRI and UNEP facilitated the
process.
The financial supplement for environmental performance emphasizes three indicators for
direct environmental impact about which financial firms should report (these were
already adopted in the GRI’s 2002 general Guidelines):
Total material use
Total waste by type and destination
Indirect green house gas emissions
In addition, the supplement presents thirteen indicators to report on a firm’s indirect
environmental impact, grouped in the following categories:
Policy: what policies does the firm apply to its core business lines?
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Systems and Processes: e.g. what processes are in place for assessing and
screening environmental risks in core business lines, for monitoring clients’
implementation and compliance with aspects raised in risk assessment processe.
Engagement: e.g. what interactions does the firm have with clients/business
partners?
Environmentally beneficial products and services: what is the total monetary value
of specific environmental products and services broken down according to the
core business line?
Activity statistics: value of portfolio for each core business broken down by
specific region and sector.
4.6.3 Reporting on sustainable credit activities by banks
The VBDO in the Netherlands has been assessing four major Dutch banks (Fortis, ABN
Amro, ING Group and Rabobank) by looking at sustainability and transparency aspects of
the banks’ credit activities (August 2003).
65
Some major conclusions of the research
report are:
1. Because there are no existing criteria among civil society and in national laws about
sustainable credit activities, banks have themselves to define sustainability and
develop criteria. In addition banks have to develop testing, measuring and reporting
methods to apply the sustainability criteria to credit activities.
2. Sustainability aspects are being taking into account by banks in their credit activities
only from a perspective of risks for the bank's reputation and risks of being
(financially) held responsible by society.
3. Reporting by the four Dutch banks in 2001 gave no clear or concrete information if
and how sustainability criteria are used in their credit activities; the very small
percentage of credits which were earmarked as sustainable (0.2% by ING, 0.4% by
Rabobank)
are striking.
4. Optimal instruments
66
to assess and monitor the sustainability of credits are difficult to
implement. Such instruments could for instance be:
i. a sustainability report of every credit, which can be obtained by the
public after request; or
ii. a sustainability certificate for each credit by the government or the
Central Bank.
One of the problems is the wish and need for confidentiality by the banking industry.
5. The two options for monitoring the sustainability of credits which seem to be feasible
and acceptable by the four researched banks are:
i. a management system that monitors how sustainability assessment
and testing of credits are being implemented, and
ii. external certification of such management systems.
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 121
6. The use by banks the GRI Sustainability Reporting Guidelines together with the
Financial Sector Supplements on social performance indicators and environmental
performance indicators would provide sufficient monitoring information, provided they
make available concrete information about criteria, indicators, monitoring methods
etc. with figures and percentages.
67
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 122
4.7 Conclusions and critical issues
1. Many possibilities, disappointing results
The initiatives of corporate social responsibility (CSR) indicate many areas where the
financial industry can:
a. avoid its negative social and environmental impact, and
b. support changes towards more sustainable societies through its core business.
In most of the financial services, these initiatives are not taken into account. For example,
the US$ 8,000bn mutual fund industry in the US invest hundreds of billions in securities of
companies without any screening for their social and environmental behaviour. In Europe,
ethical funds are only 0.36% of total assets managed on the continent and the companies
most listed in those ethical funds have often been subject to criticism for non-responsible
behaviour e.g. Shell, Citigroup.
Recent scandals at investment banks (conflicts of interest) and mutual funds
(unauthorised trading) which transferred huge illegitimate amounts of money to
management at the expense of the investing client, indicates that much still needs to be
done about basic ethical and decent behaviour in conducting the core business.
2. Wide range of CSR initiatives
At the international level, the financial industry has come up with different CSR statements
that have been signed by some of the top world banks and insurance companies. Some
are vague and general in wording, such as the CEO statement of the Business Financial
Sector Project of the World Business Council on Sustainable Development, while others
are more precise and to the point, such as the Equator Principles for project lending and
the GRI Financial Services Sector Supplement on social performance. In their
Collevecchio Declaration, NGOs go much beyond existing corporate initiatives and
request total commitment in all activities of financial firms. The Collevecchio Declaration is
the only worldwide CSR framework covering the full financial industry (although not much
about insurance) that can be used by civil society to screen private sector initiatives.
The kind of financial services that are best covered by CSR initiatives are project
financing, and asset management i.e. ethical investment by mutual funds and pension
funds. The insurance industry receives least attention from civil society while that
industry's asset management, pension insurance and insurance contracts can have a
major influence to stop unsustainable activities and support individuals and companies to
behave in a more sustainable manner.
3. Too little attention to social aspects
Social aspects, issues particular for developing countries such as Third World debt, as
well as supply chain responsibility are less covered by the CSR initiatives than
environmental aspects. References to respect of human rights and the core labour
standards of the ILO are lacking in many corporate CSR initiatives.
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 123
4. The financial industry does not allow for external assessment of CSR
initiatives
So far, it is impossible to assess whether the many CSR initiatives have made any
concrete improvement for society or have reversed environmental degradation, social
unrest or breaches of human rights. The existing CSR initiatives have not produced the
necessary external verification tools such information disclosure, impact assessments,
independent reporting, built-in continuous stakeholder accountability, etc. No tools are
offered to civil society to assess whether implementation takes place in practice or has
any real impact, and to address the financial industry to redress the problems it (helps)
create. Breaches of the Equator Principles revealed by NGOs and the free rider problems
of other CSR initiatives highlight the need of verification and redress tools.
A particular CSR problem for the financial industry is the lack of transparency argued on
the basis of bank secrecy, client confidentiality and protection of competitiveness. Much
more needs to be done than the current CSR initiatives that monitor and report only about
management. Options for more transparency in which governments and official
supervisors are involved, need to be explored. Without transparency there can be no
verification by stakeholders.
5. NGO cases reveal what needs to be changed
NGOs that have campaigned against banks involved in destructive project financing have
achieved some progress with major financial firms such as: the Equator principles that
were initiated by banks being put under campaign pressure; Citigroup's environmental
policy statement; sector policies at ABN Amro; Barclays refusal to participate in financing
the Caspian pipelines. More cases brought forward by civil society will help to reveal what
is needed and what needs to change. This is an on-going and fluid process.
6. Important dilemmas
The dilemma's facing NGOs that put pressure on financial firms to stop financing certain
projects, companies, governments of institutions are:
whether NGOs have enough power and capacity to pressure the financial
industry, one by one and collectively, in changing the negative effects of
all financial services, or whether they should seek alliance with other
stakeholders and/or the government.
whether financial firms should decide which corporations to finance, or
whether laws -supervised by the authorities- should set the criteria about
how the private financial industry should select the companies and
projects to be financed. The financial industry does not want to judge the
companies it financially supports (except for the potential financial risks
that undermines its profitability) and want to rely on regulations. On the
other hand, NGOs do not expect that governments will take sufficient
steps and expect more direct effects from undermining the financing of
destructive corporate activities.
Responsibility, of the financial firm and of the government, is clearly a
matter for debate and political attention. In 1999, the lobby of the
financial industry (the Institute of International Finance) was still of the
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 124
opinion that their only mandate was to make profit and increase
shareholder value, and that social and financial stability responsibilities
were for the government. Has this changed in practice?
7. Involvement of more stakeholders needed
NGO actions will also promote the much needed involvement of more customers, an
important segment of the stakeholders. According to research by the Dutch consumer
organisation (‘Consumentenbond’), the banks’ clients are not yet interested in CSR
principles
68
and better reporting from their banks.
CSR initiatives and reports might start drawing attention to the social and environmental
behaviour of the financial industry to another group of stakeholders: the financial firm’s
shareholders. Shareholder value needs to be looked at in ways other than simply ‘The
Bottom Line’ or ‘Share Price’. Shareholders need to know that ruthless profiteering is not
viable in the long term and that they have a choice about where they can invest their
money and earn their pensions.
8. Main elements for CSR initiatives and codes for the financial industry
What first needs to be addressed for further development of financial CSR initiatives is the
lack of a definition for sustainable development which is internationally recognised by
the financial sector and upon which screening, bench marking and reporting by the
financial industry can be based. This would allow for standards to be developed and
adopted that would make monitoring and comparison between the different financial
corporations possible.
Overall, CSR issues that are specific for the financial industry that should be included in
any CSR initiative are:
a. Transparency, verification and accountability tools.
b. The social and environmental aspects of the financial industry's own operations,
which should include respect of ILO, Human Rights and gender equality conventions
for own staff, sustainable energy use, training of staff on sustainability issues, etc.
c. Responsibility for the impact of their financial services regarding:
- Company and project financing: by using
existing overall international standards such as core ILO and Human
Rights conventions, OECD guidelines and CSR initiatives, and
International standards specific to the sector of the company or project to
be financed e.g. Forest Stewardship Council standards, standards of the
World Commission on Dams.
- Universal access, quality of services, discrimination or exclusion of poor
customers and small producers, and undue indebtness of poor customers and
poor countries: by using the Covenant of Economic, Social and Cultural Human
Rights.
- Macro-economic and financial instability:
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Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 125
the financial industry should limit its speculative products and services, short term
interest strategies in mutual funds, lack of commitment to support countries in
which they operate, lobbying for opening up financial sector markets while
adequate regulations are not in place.
- Other ethical issues:
lobbying against governmental rules that protect societal interests,
abuse of market power: see OECD Guidelines relating to competition
policy, transfer pricing and mergers,
abuse of unique market positions e.g. by investment banks or mutual
fund managers,
lax attitude towards money laundering and corruption,
support of tax evasion,
support of apartheid vs. support for black empowerment.
d. Pro-actively advancing sustainable development through:
the design of financial services (e.g. better financial terms for sustainable
behaviour),
choice of financing (e.g. renewable energy in stead of pipelines),
specific services to support the poor (beyond micro-financing), and
choice of strategies (e.g. reverse increasing consolidation and competition).
1
Information on UNEP-FI was taken from the UNEP-FI website: www.unepfi.org
2
This description was taken from: Summary of the UNEP FI 2003 Global Roundtable: Sustaining value -
A meeting on finance and sustainability: 20-21 October 2003, in Sustainable Developments, IISD,
Volume 91, nr 1, 23 October 2003 p. 1-2; for reports of UNEP-FI meetings and the different areas of
work, see: http://unepfi.net
3
See http://www.unepfi.org/signatories/statements/fi/index.html
4
See http://www.unepfi.org/work_programme/finance_and_conflict/index.html)
5
For NGO concerns on the UNEP-FI initiative, see www.banktrack.org
6
"EPI-Finance 2000": Indicators measuring the environmental performance of financial institutions, at
www.epifinance.com where the full report can be downloaded: Environmental performance indicators
for the financial industry.
7
Environmental performance indicators for the financial industry, p. 12.
8
The categorisation used in this table is not the one used in this SOMO report.
9
See http://www.wbcsd.org/DocRoot/5PV72pFXVXcIqJX88UlC/20020925_finance.pdf
10
See http://www.unglobalcompact.org/content/NewsDocs/WhoCaresWins.pdf
11
This description is taken from the Wolfsberg Principles website: www.wolfsberg-principles.com; Mark
Pieth & Gemma Aiolfi, The Private Sector becomes active: the Wolfsberg Process,
at: http://www.wolfsberg-principles.com/pdf/wolfsbergprocess.pdf
12
Wolfsberg Anti-Money laundering Principles on Private Banking, article 1.1, at www.wolfsberg-
principles.com
13
Environmental NGOs taking the initiative were amongst others: Friends of the Earth, Wilderness
Society World Wildlife Fund (WWF), Campagna per la Riforma della Banca Mondiale, Berne
Declaration and others
14
See www.banktrack.org
15
See www.banktrack.org; see also chapter 5, annex to the conclusions.
16
For a short insight, see www.somo.nl, and www.observatoriosocial.org.br
17
Full report to be published at the beginning of 2004 by BWI and SOMO
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 126
18
Bank Track, No U-turn allowed: NGO recommendations to the Equator banks, 23 January 2004.
19
See for instance actions against Citigroup, the largest financial services provider in the world, on
website of different NGOs and one particularly focussing at Citigroup (e.g.
http://www.ran.org/ran_campaigns/global_finance/)
20
See for instance www.banktrack.org
21
See http://www.equator-principles.com/principles.shtml
22
See http://www.equator-principles.com/faq.shtml
23
J. Sohn, NGO spotlight shifts to private sector, in Environmental Finance Magazine, February 2004.;
see www.equator-principles.com for details and figures.
24
Rainforest Action Network and Citigroup announce enhanced Citigroup environmental policy, press
release by Citigroup and Rainforest Action Network, 22 January 2004.
25
See: www.brettonwoodsproject.org/update/
26
At the SOMO workshop on CSR and the financial sector (The Hague, 19 November 2003), it was
revealed that during a conversation between NGOs and a bank that had adopted the Equator
Principles, the bank admitted that if current controversial projects would be screened using the Equator
Principles, the projects would be approved.
27
See Bank Track letter to the 'Equator Banks', Amsterdam 10 December 2003.
28
in Turkey, Azerbaijan and Georgia, see www.baku.org.uk; see Evaluation of compliance of the Baku
Tbilisi Ceyhan pipeline with the Equator Principles, October 2003.
29
See www.amazonwatch.org
30
See: www.banktrack.org which replaces the www.financeadvocacy.org website
J1
See: www.panda.org
J2
Bank Track, No U-turn allowed: NGO recommendations to the Equator banks, 23 January 2004.
JJ
This can for instance be seen from the indicators of the EPI-Finance 2000 report: Environmental
performance indicators for the financial industry, p. 24
34
For example, in the Netherlands a committee of commercial banks and consumer organisation is trying
to improve accessibility of financial services outside of urban areas, called “Maatschappelijk overleg
betalingsverkeer”, see Erica Verdegaal, Winkels, consumenten en banken kunnen niet zonder elkaar.
Knelpunten en oplossingen bankdiensten in kaart gebracht, in DNB Magazine, De Nederlandsche
Bank, no. 1, 2005
35
See EBRD website: www.ebrd.org
36
See the ‘international year of Microcredit’ website: http://www.yearofmicrocredit.org/
37
See http://www.strohalm.net/en/site.php
38
Based on a presentation of VBDO (Dutch Organization of Investors for Sustainable Development,
www.vbdo.nl) on SOMO workshop, January 13
th
, 2005, Amsterdam.
39
See http://www.sustainability-index.com/
40
See http://www.ftse.com/ftse4good/
41
More information at: www.siricompany.org
42
www.siricompany.com (There were more than 1000 profiles at the end of 2002)
43
www.sirigroup.org/services.shtml
44
Green, social and ethical funds in Europe 2004, SiRi Group - Avanzi, Milano, November 2004, at
http://www.ecodes.org/documentos/archivo/Fondos_Europa_2004.pdf
45
To assess the behaviour of these companies from a NGO CSR perspective, see for instance
www.transnationale.org
46
http://www.bijsluiterscore.info/P_INGBank_DuurzaamRendementFonds_028.htm
47
For example, the UK Just Pension’s; see: www.uksif.org
48
Ibid.
49
EIRIS, Responsible investment: EIRIS reveals SRI practices of top pension funds, press release, 19
May 2003.
50
Christel Witteveen, Groot geheim. Het beleggingsbeleid van pensioenfondsen, in People, Planet Profit,
Volume 3, no 2, Winter 2004/5
Critical Issues in the Financial Industry
Chapter 4 – Corporate Social Responsibility initiatives in the Financial Sector 127
51
Challenges for the South in the WTO Negotiations on Services - Summaries and Conclusions from
Three Case Studies: Health Care (Kenya), Electricity (Colombia), Tourism (India), published by SOMO
and Wemos, January 2002 (see: www.somo.nl)
52
GRI, Financial Services Sector Supplement: social performance, November 2002, at
http://www.globalreporting.org/guidelines/sectors/GRIFinancialServices.pdf
53
See: Risk, the environment and the role fo the insurance industry, prepared by the UNEP FI
Australasian Advisory Committee on Insurance, EPA VICTORIA - UNEP Finance Initiatives, January
2003, p.5-7.
54
this insurance is developed in cooperation with BUND, the German section of Friends of the Earth:
Fourth International Conference of the UNEP Insurance Industry Initiative: Natural capital at risk -
sharing practical experiences from the insurance and investment industries. Executive summary report,
UNEP, September 1999, p.13.
55
See: Risk, the environment and the role of the insurance industry, prepared by the UNEP FI
Australasian Advisory Committee on Insurance, EPA VICTORIA - UNEP Finance Initiatives, January
2003, p.16-18, 32-36.
56
See http://www.unepfi.org/signatories/statements/index.html
57
See http://unepfi.net/iii/signatories_country.htm ; the figures relate to December 2003
58
See www.interpolis.nl; Interpolis, Micro-insurance in developing countries, at
http://www.mian.nl/docs/00355%20Micro-insurance.pdf
59
See for instance: http://econjustice.net/wbbb/
60
For more details, see CEO Briefing on emissions trading, January 2004, at http://unepfi.net
61
Non-final version but ready to use, test and provide feed back.
62
The SPI-Finance companies that were involved were: Co-operative Insurance, Credit Suisse
Group,Development Bank of Southern Africa, Deutsche Bank AG, Rabobank, Swiss Re, The Co-
operative Bank, UBS AG, Westpac Banking Corporation, Zürcher Kantonalbank, Interpolis, Rheinland
Versicherungen, Swiss Life, XL Winterthur International (see Social Performance Indicators for the
Financial Industry (SPI-Finance 2002))
6J
See annex: indicators of management performance relate to policies and activities, and operational
performance relate to results of policies and activities.
64
Letter (16 December 2002) to GRI by Berne Declaration, Campagna per la Riforma della Banca
Mondiale, Euronature, Friends of the Earth, Mineral Policy Institute, Rainforest Action Network, Power
Shift, Wilderness Society World Wildlife Fund United Kingdom.
65
R.F. Faber, Duurzame kredietverlening - Transparantie van duurzaamheid bij het rentmargebedrijf van
banken, VBDO Onderzoeksrapport, August 2003 (see www.vbdo.nl)
66
See: Ibidem, p. 7.
67
For full overview of the VBDO's recommendations on this issue, see: Ibidem, p. 11.
68
Consumentengids, December 2003.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 128
Chapter 5
Governmental regulations
at the international level
Introduction
The behaviour of the financial industry is influenced by regulations and implementation of
these regulations (supervision). Almost all binding rules and supervisory mechanisms are
still based at the national or EU level. However, many international institutions try to
influence national regulation and supervision even though their means of enforcement is
often limited to cooperation and peer pressure.
In the light of the growing trend towards internationally operating financial services
providers, this chapter identifies the major institutions at international level which deal with
the regulation and supervision of the behaviour of financial firms in the area of banking,
insurance and securities. Because it was beyond the scope of this report to analyse each
of the different national regulation and supervision systems, this chapter identified some
national trends worldwide.
In a second part, this chapter attempts to assess the impact of the consolidation of the
financial industry in relation to financial stability and the institutions that promote financial
stability.
In the following chapter 6, the international regulations about trade in financial services
under the WTO are analysed.
5.1 Trends of regulation and supervision at national levels
Many countries have systems to regulate and supervise banks, and other financial
services, in order to prevent that the risks taken by the financial industry would have
negative effects on society. However, regulation and supervision also have a decisive
influence on the development and structure of the financial services sector in each
country. This explains why the structure of the banking industries continues to differ
greatly across countries in the West, ranging from very non-concentrated banking in a few
countries (e.g. Germany) to highly concentrated in other countries (e.g. Australia, Belgium,
Canada, France, the Netherlands and Sweden).
1
National differences in regulation and supervision
The clear differences
2
that can still be observed in bank regulation and supervision in
various countries depend on:
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 129
(a) whether the national authorities follow a liberal approach and allow national
or international mergers and acquisitions of their banks (with differences in
preferring domestic banking consolidation or acquisitions of national banks by
foreign ones), or whether they want to stick to a more rigid and regulated
approach and restrict foreign or national take-overs. Banks in countries with the
latter approach are now assumed to have low levels of consolidation and to face
increasing international competition from larger financial corporations, resulting in
the challenge of being acquired by foreign financial corporations, or hardly play a
role of importance internationally.
(b) the attitude of the regulators in situations where banks are confronted with real
or emerging problems: authorities can adopt a proactive and strict approach,
whereby they set high standards of prudential control and take the tough
measures to resolve the problems at an early stage; or they can follow a passive
and/or soft approach (for political or cultural reasons). The latter approach is
typical for Japan, resulting in a continuing weak financial system with a huge
amount of bad loans, weak capital reserves, low profitability and demands for
government bailouts.
The significant regulatory differences between the EU and the US have lead to intensive
discussions. For instance, the European financial services industry fears that European
regulation tends to open up the market for US services while the US is having a
"regulatory revival" that harms the European financial industry.
3
This might lead to bilateral
informal discussions and solutions in which the rest of the world is not involved to make
their case.
4
Liberalisation trends in developing countries
In many developing countries, regulation has changed from hands-on regulation to more
indirect regulation. Governmental fixing of interest rates and control over allocation of
credit is seen as the cause of inefficiency, unfair lending and services, and low interest
rates that encouraged capital flight. Under pressure from the World Bank, the IMF and the
international liberalisation paradigm, controls on interest rates were relaxed, restrictions
on capital flows and foreign financial service providers removed, the banking system
restructured and given more capital.
5
At the same time, a financial "safety net" was
promoted by which each country would have prudential regulation and supervision, a
lender of last resort and deposit insurance. As could be seen in the case study of
Indonesia (chapter 3), deregulation was not always accompanied by good supervision and
regulation, and was undermined by corruption. Even if good standards of regulation and
supervision are in place, many developing countries have been struggling with lack of
qualifications, sufficiently equipped personnel, and support by the legal system.
6
Difficulties in supervision
Supervisors and regulators still do not have everything under control. This is shown
amongst others by the credit card crisis in South Korea since the end of 2003. Too much
unpaid credit was leading to the collapse of the main credit card company, which could
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 130
have severe consequences for the South Korean banking system and the economy. The
government was intervening, thus abandoning the principle that private banking should be
left to the markets even if they fail.
7
In different countries, including the US and Australia,
supervisors are struggling with scandals of illegal, unfair or too risky practices by financial
firms or some of their staff members.
Following (!) increasing consolidation of financial firms, some countries have reformed
their supervision and are bringing the different financial industry sectors -banking,
insurance, securities- under one supervisory institution or umbrella. This process is at
different stages in many countries. For instance, Italy just started to discuss such a reform
after the Parmalat scandal at the end of 2003. The challenge in such reforms is that such
reforms do not get politicised and lead to battles between different authorities wanting to
keep supervision.
8
International competition undermines national regulation and tax income
Also, international fierce competition can make it difficult for regulators to create prudential
laws or laws that protect consumers (e.g. obligation to lend to poorer buyers of houses).
They will often be threatened by arguments from the national and foreign financial industry
that new regulations will make the country and its financial industry uncompetitive
compared to the financial industry based in other countries. For instance, when banks
were closing rural branches in the Netherlands it was difficult for the government to
legislate them to remain open. In the worst case, banks threaten to withdraw their
operations from a country where they see legislation as undermining their profits.
International competition also explains the existence of offshore centres since some
governments want to promote their financial industry and their financial markets. Offshore
centres
9
are mostly small islands, such as the Cayman Islands, and small countries, such
as Singapore. They offer bank secrecy, low taxes or tax exemptions for foreign capital.
These offshore centres attract untaxed capital flows from other countries and are
suspected of money laundering and transfer criminal money. Most internationally
operating financial firms and accountancy firms have branches and services at, and
related to, offshore centres; this provides an income for these industries and the offshore
authorities. The US banking industry is the biggest user of offshore centres, especially the
Cayman Islands and Jersey.
10
Being put under pressure by international bodies and the EU, offshore centres' authorities
are formally improving their handling of money laundering and money deposits from
dictators while compulsory/binding measures at international level are still lacking.
11
Critical issues
Many national supervisory and regulatory regimes are not yet ready to cope with
increasing international competition and consolidation in the financial industry.
This competition and consolidation can have a chilling effect on national efforts to
appropriately regulate and protect consumers and poorer banking clients. This
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 131
could explain why national regulators are not intervening sufficiently to deal with
the many critical issues and problems explained in the previous chapters.
The few initiatives that exist to specifically encourage financing services and
financial firms to reduce poverty and promote sustainable development mostly
exist at national and EU level, not at international level. Examples are:
Tax free green funds: mutual funds exempt from interest and dividend
income tax e.g. in the Netherlands where green funds have been growing
faster than in other countries.
Disclosing ethical investment policies: laws requiring pension funds to
disclose their ethical investment policies and practices, as was
introduced in the United Kingdom.
The US Community Re-Investment Act (CRA): requires banks to invest a
certain portion of their portfolio in the local economy where the bank is
based, especially supporting those consumers that are historically
marginalized. The CRA has helped create an entire sub-sector of
community development financial institutions in the United States, which
specialize in providing access to capital and credit to low-income and
distressed communities.
12
5.2 Regional financial services markets and regulation
At the EU level, many changes in laws and regulations are being undertaken to create a
single financial services market (European Financial Services Action Plan). By 2005, all
financial services and financial markets are supposed to be liberalised to make different
(sub-)sectors of the EU financial industry compete against each other.
13
In this context,
the EU has been working on EU-wide supervision and regulation, including on financial
conglomerates that combine banking, insurance and securities' services, and on
eliminating tax evasion through tax havens and off shore centres. The new European
financial institutions work in a decentralised way to refine and implement EU financial
regulations
14
:
The Committee of European Banking Supervisors (CEBS)
The Committee of European Insurance and Occupational Pension supervisors
(CEIOPS)
The Committee of European Securities Regulators (CESR)
Other regions and free trade areas are equally setting up regional regulatory and
supervisory agencies. For instance, the Eastern Caribbean Central Bank covers 9 small
island members
15
in the Caribbean region.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 132
5.3 International regulation and supervision of corporate
financial services
Different international institutions set standards for national regulators and develop
measures to deal with cross-border activities of financial firms. Developing countries are
not always member of these international institutions or standard setting committees. The
standards, principles, agreements, guidelines and recommendations for regulation and
supervision made by these institutions do not have the status of international law. Their
status contrasts with the international binding agreements and rules of the World Trade
Organisation and the enforcement through the WTO mechanism that settles disputes
when members do not observe a WTO rule.
Many non-binding international financial standards may not yet be implemented,
especially not in developing countries. This state of affairs needs to be seen not only in
the context of increasing consolidation but also continuing worldwide arrangements to
liberalize trade in financial services. Complex Western financial conglomerates get the
right to operate in many developing countries even if international financial regulatory
standards are not generally applied (see chapter 6 about GATS).
The financial services industry itself is interested in having more equal rules and
supervision in all the countries in which it operates. This would create a "level playing
field" whereby foreign financial firms enjoy the same opportunities to compete in all
countries without being hindered by different requirements or preferences for national
financial firms. On the one hand, the financial industry is often heavily involved in
international standard setting bodies to stop any standard that would put too many
restrictions on their international operations or be too costly to implement. On the other
hand, the financial industry considers the current level of international regulatory
coordination (see below in this chapter) as insufficient.
The major international institutions that deal with regulation and supervision of financial
services are described in the following paragraphs. They are first mentioned in a short
oversight
16
with basic references; the most important institutions are more fully described
thereafter. The institutions that equally deal with the regulation and supervision of capital
flows and international financial system are briefly mentioned in the final parts of this
chapter.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 133
Short oversight of international supervisory and regulatory bodies
Basel Committee on Banking Supervision (BCBS): The BCBS provides an important
forum for regular cooperation among its 13 member countries on banking supervisory
matters. The BCBS formulates broad supervisory standards and guidelines and
recommends statements of best practice in banking, in the expectation that bank
supervisory authorities will take steps to implement them.
http://www.bis.org/bcbs/index.htm
International Association of Deposit Insurers (IADI): The IADI promotes international
cooperation and exchange of know-how among deposit insurers and other interested
parties. It aims at contributing to financial stability by providing guidance for more effective
deposit insurance and enhancing understanding of common interests.
http://www.iadi.org
International Association of Insurance Supervisors (IAIS): The IAIS allows insurance
regulators and supervisors from more than 100 jurisdictions to cooperate. It is charged
with developing internationally endorsed principles and standards that are fundamental to
effective insurance regulation and supervision.
http://www.iaisweb.org
International Organisation of Securities Commissions (IOSCO): IOSCO brings
national regulators together to develop and promote standards to regulate markets dealing
in securities and futures. It also develops standards for effective surveillance of
international securities markets. It provides mutual assistance to promote a rigorous
application of the standards and effective enforcement against offences in order to
safeguard the integrity of securities' markets.
http://www.iosco.org
Committee on Payment and Settlement Systems (CPSS): The CPSS monitors and
analyses developments in domestic payment, payment settlement and clearing systems
as well as in cross-border schemes by Central Banks and the private sector. The CPSS
deals with the different systems that settle the transfer nationally and worldwide of several
trillion dollars per day from interbank and other large value payments, transactions in
securities (including lending of securities) and derivatives, foreign exchanges, central
banks, and retail banking activities. The CPSS formulates broad supervisory standards
and guidelines for best practice, in the expectation that bank supervisory authorities will
take steps to implement them at national level. It has developed a common set of
universal international standards for payment systems: the “Core Principles for
Systematically Important Payments Systems”, published in January 2001. It has so far
failed to work out currency taxes such as a Tobin tax to slow down the billions of
international speculative capital flows.
http://www.bis.org/cpss/
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 134
CPSS-IOSCO Task Force on Securities Settlement Systems: The CPSS and the
Technical Committee of IOSCO set up a task force to jointly issue recommendations for
securities settlement systems.
http://www.bis.org/cpss/index.htm; http://www.iosco.org
BCBS Transparency Group and IOSCO TC Working Party on the Regulation of
Financial Intermediaries: Together both bodies made recommendations for public
disclosure of trading in securities and derivative activities of banks and securities firms.
They complement the surveys by both Committees on disclosure of trading and
derivatives by banks and securities firms. Such surveys have been published annually
since 1995. Both initiatives form part of a continued effort to encourage banks and
securities firms to provide market participants with sufficient information to understand the
risks inherent in their trading and derivative activities.
http://www.bis.org/bcbs/index.htm; http://www.iosco.org
5.3.1 Bank for International Settlements (BIS)
The Bank for International Settlements (BIS)
17
is an international organisation that was
established in Basel (Switzerland) in 1930 and serves as a bank for central banks. The
BIS currently has 55
18
member central banks. The aim of the BIS is to promote
international exchange of expertise and cooperation on national and international
monetary and financial issues. The different Committees of the BIS have agreed upon
some arrangements to regulate and supervise particular banking issues in order to
achieve financial stability. The committees determine their own agenda and operate
independently from the BIS' governing bodies. The Basel Committee on Banking
Supervision is the most important committee.
Developing banking supervisory cooperation and standards: the "Basel
Committee"
The Basel Committee on Banking Supervision started in 1974 as a forum for regular
cooperation between banking supervisors of 10 Western countries (G-10) and exists
currently of supervisory authorities and central banks of 13, developed, countries.
19
It is
referred to as the "Basel Committee" and has subgroups that deal with particular banking
supervision issues (e.g. securitization). The Committee consults and exchanges know-
how with supervisors of other countries that have important financial industries. It has a
strong focus on strengthening prudential supervisory standards in so-called, non member,
emerging markets. The Committee also has close links with the international banking
industry, assuming that these links help to forge consensus. There are no particular
consultative bodies with other actors of society but consultative papers often request for
comments, by any one, by a certain deadline and informal consultations take place with
private banks.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 135
Arrangements to supervise nationally and internationally operating banks
The Basel Committee has gradually developed common international standards of
banking supervision that are to be implemented through national legislation. It has
increasingly become a standard-setting body on all aspects of banking supervision and
best banking practices. The Committee, however, has no international means of
enforcement. The standards aim at preventing erosion of regulation when national
authorities want to attract foreign investment in financial services or protect their financial
services industry against foreign competitors. The Committee is concerned about
intensification of international competition in countries with insufficient supervision.
The main important instruments developed by the Basel Committee are:
- The Basel Committee’s Concordat embodying principles of effective banking
supervision:
In 1975, after a crisis in the foreign exchange markets, the Concordat established the
principle that the home country authorities would supervise some establishments of
worldwide operating banks. The concordat was strengthened several times, for instance in
1983
20
, and in the aftermath of one of the biggest ever collapse of a financial company,
the Bank of Credit and Commerce International (BCCI) in 1991
21
. Especially branches of
international banks are to be supervised by the authorities of the parent bank. Supervision
of subsidiaries and other activities of banks' foreign establishments is to be done jointly by
the host and home country authorities. In 1990, recommendations were made to improve
information exchange between host and home supervisors because it was often
inadequate.
22
- The Basel Committee's Minimum Standards for the supervision of international banking
groups and their cross border establishments:
These standards, agreed upon in 1992, provide the right of the home country supervisors
to obtain data needed for the consolidated supervision of international banks and
strengthen the host countries’ authority to impose restrictive measures if the minimum
standards are not met. Such prudential measures include imposing deadlines for meeting
acceptable standards, obliging foreign branches to be restructured so as to have sufficient
capital reserves, and even closing banking establishments.
23
- The Basel Committee’s 25 Core Principles for Effective Banking Supervision:
These 25 core principles were agreed upon in September 1997 after the G-10 also
consulted authorities of "emerging markets". They represent the basic elements for an
effective banking supervisory system in each country. Supervisory authorities throughout
the world were invited to endorse the principles. By endorsing, countries agreed to have
their supervisory arrangements reviewed against the principles.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 136
Regulation of capital reserves for lending: the Basel Capital Accord and its
renewal
"Basel I": a major international standard of banking supervision
The supervisors of the Basel Committee agreed in 1988 on the amount of financial
reserves they require all banks to put aside when providing loans. This agreement about
the "capital requirements" by supervisors to their banking industries was called the "Basel
Capital Accord" and was updated several times to avoid misunderstandings and major
gaps. The aim was to address "credit risks" in order to avoid that banks would go bankrupt
by a series of bad loans that were not being repaid. Because of competition,
internationally operating banks were holding as less capital reserves as possible. The
danger was that the banks' reserves were becoming too low to recover from major non-
performing loans.
The basic principles of the Basel Accord are:
A bank has to put aside 8%, or less, of the amount of the loan as a reserve,
depending on the assessment of the risks of a loan.
Banks have to make assessments in how far a loan will not be repaid based on three
categories, i.e. governments, banks and corporations. For instance, a bank that gives
a loan to a government in an OECD-country has to put no money aside because the
risks of non-repayment are none according to the Basel principles. According to Basel
I, banks have to put aside 8% of all loans provided to any corporation. In practice,
however, loans to large companies are assessed to have less risks of non-
performance and are therefore provided at lower interest rates by banks compared to
loans to small and medium-sized companies.
Table: Basel I risk assessment framework
% credit risk in OECD
countries*
% credit risk in non-OECD
countries*
Official authorities (e.g.
governments)
0% 100%
Banks:
-loans up to 12 months
-loans of 12 months and
longer
20%
20%
20%
100%
Corporations 100% 100%
* 100% risk means banks have to put 8% of the amount of the loan aside as a reserve
Source: |. |etzger, 8asel ÌÌ · 8enefIts for 0evelopIng CountrIes, 8ÌF
WorkIng Paper Nr. 2 /2004 (based on 8asel CommIttee 1988)
Banks that give loans to other banks have to distinguish between short term loans (up
to 12 months) and long term loans. According to Basel I, the risk of providing short
term loans to banks is much less (only 20% risk) than long term loans (100% risk in
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 137
developing countries). Because the financial crisis in Asia (1997-'98) was caused
amongst others by short term loans given by Western banks to local banks in South
East Asia, the Basel Committee has started to draw up new principles according to
which banks have to assess the risks of a loan.
By 1994, the original Basel Accord was being implemented in over 100 countries. The
Accord Implementation Group was set up by the Basel Committee to share experiences
and promote implementation.
"Basel II": a significant reform that affects the banking industry worldwide
In May 2004 the Basle member countries reached a consensus on a new capital Accord,
dubbed Basel II, that will introduce some important reforms in banking sector supervision
related to credit risk management. Basel II intends to make the banking system more
stable and efficient by enabling banks to hold capital reserves based on a more
sophisticated risk assessment of their credit provisions to others. The new accord is to be
implemented by the end of the year 2006.
It has to be noted, however, that the exact implementation process is unclear. Already in
the preparation phase, there was much controversy surrounding the new accord.
Proposals proved to be heavily influenced by international operating banks, for instance
through the Institute of International Finance.
24
Even before the text Basel II had been
agreed upon, the US and China already announced that they would pursue other
regulations for most of their (national) banks
25
so that not all banks will apply Basel II as
originally conceived. The US House Financial Services Committee feared that Basel II will
disadvantage smaller US banks who have no capacity to apply Basel II, and increase the
concentration in the banking industry.
26
As for the European Union, the EC is planning to implement to entire new accord into a
third European Capital Adequacy Directive (CAD3), which will make the Basel II principles
applicable to all European credit institutions.
As for less developed countries, the Basel Committee acknowledged that the adoption of
Basel II might not be the first priority of supervisors in those countries. They should focus
more on the implementation of pillar 2 and 3 of the Accord (supervisory process and
market discipline), rather than on the complex reserve requirements of pillar 1.
27
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 138
Box: The main elements of the new Basel II accord
The text of the new accord (Basel II) is a complex document of 250 pages. It is based on three
pillars:
Pillar 1: New risk assessment mechanisms and resulting capital requirements:
New categories are introduced on how loans to governments, banks and corporations need to
be assessed, as well as new minimum capital reserve requirements.
Different approaches to measure credit risk:
a "standardised approach" to measure the risks of a borrower, where banks for their credit
assessments depend on corporate rating agencies (see chapter 1) that assess solvency; or
a bank can use its own risk estimation systems ("Internal rate based approach" or IRB
approach) and comply with certain criteria and information disclosures, e.g. sufficient auditing.
Banks increasingly transfer their asset risks to outside investors through securitization, and
therefore Basel II has introduced a securitization framework to assess the risks associated with
this and to determine the resulting regulatory capital requirements. Again, the accord offers a
standardized approach, and the option to use an internal rate based approach. The capital
reserve requirements depend on the approach used.
28
Introduction of capital requirements for operational risk, the risk associated with the internal
processes of the bank. Basel II offers 3 different approaches, varying in complexity, to assess
these risks.
A final element of the first pillar concerns the trading book. The trading book (in contrast to the
banking book) gives an overview of a bank’s financial instruments it holds for trading purposes.
This balance has become much more important for banks, and clearer rules are introduced on
how to treat trading book issues.
Pillar 2: Changes in the supervisory processes:
Banking supervisors get more power and scope to intervene and monitor risk assessment
systems of banks.
Banking supervisors of the home countries and host countries of banks are required to improve
their cooperation and information exchange and make concrete plans thereto, and decrease
the burden of banks to implement supervisory requirements.
29
Pillar 3: Market discipline through better disclosure of information by banks:
Banks have to publicise more differentiated data. The assumption is that when data indicate
bad banking behaviour, e.g. too many risky loans, the clients and investors will react and put
pressure on the bank.
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Chapter 5 – Governmental regulations at the international level 139
Critical issues about "Basel II"
In the preparation phase of the new accord, the Basel Committee had already
requested, and received, comments on its three consultative papers. There have
been many articles by experts who have criticised the Basel II proposals. The
definite version of the Accord has not taken account of many of these critiques. In
the end, it seems that the major aim of Basel II is avoiding that Western
governments would have to bail out the large consolidated Western private banks
in case they fail.
The overview below sums up some problems for developing countries and
safeguarding financial stability.
30
Developing countries not represented
The Basel Committee that negotiated and designed the Basel II Accord did not
have representatives of developing countries among its members. The Committee
did hold regular meetings with a group of 13 non-member countries, including
Russia and China, to review its work and comment upon it. However, the new
capital accord Basel II failed to take account of the interests of developing
countries who had no decision-making power in the design.
Loans to developing countries more expensive?
Governments, banks and corporations in developing countries will probably face
higher costs for loans due to Basel II. First of all, this could be the case since they
generally receive low ratings by rating agencies or by the banks' own risks
assessment systems. Many companies or governments from developing
countries have no rating at all. These lower or non-existing ratings do not always
reflect actual creditworthiness of the corporations or governments and can reflect
some bias in capital markets. According to the “internal ratings based” (IRB)
approach in Basel II, banks do need to put more capital aside for such lowly or
non-rated lenders. In practice, this would mean that higher interest rates will be
charged for many loans to developing countries compared to the developed
world.
Secondly, interest rates charged to the developing world as a whole could be too
high because of the lack of diversification considerations, which Basel II has
chosen not to include in its risk assessment mechanism. The economies of the
developing world are normally less related to the developed world as a whole, so
that they are much less affected in case of a crisis in the industrialized world. To
avoid risks, banks should therefore not only diversify their credit portfolio among
sectors, but also among the developed and developing world. There exist tools to
assess investment risks that take those diversification considerations into
account. However, the mechanisms adopted in the Basel II accord haven’t
integrated them. As a result, the estimated credit risk of loans to developing
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 140
countries could lay as much as 20% too high
31
and, consequently charged
interest rates could be much too high as well.
A positive consequence of the higher reserve requirements, on the other hand,
could be that it would become easier for banks to reduce developing countries’
debt burden by writing off loans. Since banks have already better covered for
non-performance, by making higher provisions for a loan to a developing country,
writing off such a loan would be relatively less costly for a bank.
International banks get competitive advantage
Banks that use their own risk assessment system have to use their system for all
the loans they provide in all countries. The costs of introducing and operating own
risk assessment systems are expensive and especially feasible for the top of
internationally operating banks. Consequently, the different banks that operate in
a particular developing country might use different risk assessment approaches
with different capital reserve requirements. This would give international banks
that use their own risk assessment system ('Internal rate based' approach (IRB)'
with less capital requirements) a competitive advantage over domestic banks that
use a standardised approach requiring higher loan reserves.
Too complex tasks for supervisors?
The question remains whether supervisors will be able to duly supervise the
implementation of the banks' own risks assessment mechanisms (IRB approach).
During the design of Basel II supervisors indicated that they did not fully
comprehend these risk assessment systems.
32
Supervision of banks that use
their internal ratings mechanisms will require supervisors to work closely together
with those banks. The supervisory bodies will also have to invest heavily in their
own expertise to ensure they can actually judge the banks’ assessments. It is
doubtful whether the regulatory regime is strong enough for this.
33
Danger of financial instability not resolved
Short term loans are still treated more favourably than long term loans because of
the much lower reserve requirements attached to the former. Although the Asian
financial crisis has shown that short term loans can be the source of major
financial instability, the new Accord hasn’t taken this into account.
34
Another
potential danger to financial stability lies in the possible procyclical effects of the
use of external rating agencies for the assessment of risks. When a country is
temporarily not doing too well, and rating agencies start to lower credit ratings,
this could only aggravate the situation.
35
Lack of assessing environmental and social risks of the borrowing
companies and governments
One critique professional experts have not publicly raised is that assessing credit
risks should also take into account the risks for sustainable development, i.e. the
environmental degradation, the social and societal impacts of the companies and
projects that receive bank loans. The Basel II only has an obligation to banks to
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 141
assess environmental risks that undermine the value of the collateral of the
borrowing company.
36
Other assessment mechanisms more useful
37
There are other ways that would be helpful to prevent financial instability and
bailing out. Such alternative system would be based on the systemic risks a bank
poses to the international financial system: The more a bank is big and
internationally interconnected, the higher the capital requirements should be; also,
the better the bank is in predicting and assessing risks, the less capital reserves it
would have to put aside. In addition, capital requirements should not remain the
same at any time but be raised in times of financial instability and crisis.
5.3.2 International Association of Insurance Supervisors
(IAIS)
38
The IAIS was established in 1994 to promote cooperation and transfer of know how
among insurance supervisors. It is charged with providing guidance and developing
internationally endorsed principles and standards that are fundamental to effective
insurance regulation and supervision. It strives to contribute to financial stability and
coordinates with regulators of other financial sectors.
IAIS members are insurance supervisory authorities from more than 100 jurisdictions. In
addition, there are 70 observers form professional organisations, insurance and
reinsurance companies, international financial institutions, and other individual
professionals.
The IAIS has 21 working parties meeting 3 to 4 times a year and dealing with particular
issues of the insurance industry such as accounting, reinsurance, insurance fraud,
electronic commerce, investments, emerging markets, disclosure and transparency.
Through its working parties, IAIS members have developed and approved several
standards of which important ones are:
The IAIS Core Principles and Methodology for effective operation of supervisory
systems (2000): the principles were updated in October 2003 to add issues of
transparency of the supervisory process, risk assessment, consumer protection
and anti-money laundering.
The Insurance Concordat (1999): covers principles to improve the supervision of
internationally operating insurance companies and their cross-border business
operations, including cross border insurance business that is conducted without
foreign establishment (e.g. through internet). The concordat promotes
cooperation between supervisors from the home and the host countries.
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Chapter 5 – Governmental regulations at the international level 142
IAIS's recent work on standard setting has focused on developing standards in the areas
of:
solvency;
cross-border service provision;
asset risk management;
group coordination of financial conglomerates;
reinsurance;
market conduct;
electronic commerce;
accounting standards (whereby it works closely together with the International
Accounting Standards Board, see 5.5)
In 2003 it also published a study about the risk of some 15-20 insurance companies
buying credit derivatives (see chapter 1), and other issues of credit risk transfer between
insurance, banking and other financial firms. The study was inconclusive as it indicated
that it is difficult to gather all the relevant global data but suggested that credit derivatives
were only a relatively small proportion of insurers' investments, and thus not posing major
risks of transferring risks from the banking to the insurance industry.
39
5.3.3 International Organisation of Securities Commissions
(IOSCO)
40
Since 1983, IOSCO has been bringing national securities regulators together to cooperate
and exchange experiences in order to maintain "just, efficient and sound" securities
markets. It has been developing principles and practices for sound regulation of securities
markets and financial firms, and standards for effective surveillance of international
securities markets. It provides mutual assistance to promote application of the standards
and effective enforcement against offences.
IOSCO is recognised as being the international standard setter for the securities industry
although it has no other mechanisms to enforce its resolutions, statement and standards
than screening regulations, naming and shaming, and cooperation.
The ordinary members include securities regulators of over 100 jurisdictions. "Self
regulating bodies" such as the stock exchanges (which are in private corporate hands)
can become affiliate members or even ordinary members if coming from a country without
governmental securities regulatory bodies. IOSCO has several committees according to
regions and the development of the securities' market, including an Emerging Markets
Committee.
The importance of IOSCO became clear during the South East Asian financial crisis in
1997-98. The "emerging markets" had seen the cross-border trade in their securities grow
very rapidly, amongst others by deregulation, and trading by Western financial firms and
mutual funds. When uncertainty about South East Asia's financial stability hit the
securities markets, high volatility in securities trading followed from investors and banks
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Chapter 5 – Governmental regulations at the international level 143
selling off their shares in search of short term protection against losses. The financial firms
that traded in securities gained from the fees of increased trading but the resulting
volatility in exchange rates and devaluation in the South East Asian currencies and
companies' shares was so severe that it contributed to the economic and social downturn
of those countries.
In 1998, IOSCO issued the 'IOSCO principles', a document with 30 principles which
securities regulators committed themselves to implement, aiming at:
1. protecting the investors,
2. ensuring fair, efficient and transparent markets,
3. reduction of systemic risk.
These "Objectives and Principles of Securities Regulation" have been recognized as key
standards for a stable and well functioning securities market and were updated in 2002.
Promoting these principles, which are not legally binding, is one of IOSCO's highest
priorities, supported by a task force, and self-assessment mechanisms for its members.
The IOSCO principles were strengthened by the adoption of the “Multilateral
Memorandum of Understanding Concerning Consultation and Cooperation and Exchange
of Information” (“IOSCO MOU”), This agreement should enhance the enforcement of the
principles and avoid the use of securities for criminal purpose. Many IOSCO members
could not yet subscribe to the IOSCO MOU because they could not implement all the
Principles. At the end of 2004, only 26 out of the 105 IOSCO members had signed the
MOU. On the other hand, some members already had such cooperation agreements at
bilateral level ("bilateral MOUs").
IOSCO followed the general line by supervisors and regulators after the financial crisis
that more disclosure of information can avoid a financial crisis. For instance, in 1999
IOSCO issued "Recommendations for public disclosure of trading and derivatives
activities of banks and securities firms" in cooperation with the Basel Committee on
Banking Supervision.
41
In September 2003, IOSCO issued a Statement
42
with general principles to guide
securities regulators in addressing conflicts of interest faced by financial analysts.
43
This
was a response after scandals had uncovered that securities analysts were advising
investors to buy securities from companies which were clients from other divisions in the
financial firm of the securities analysts (conflict of interest). Although IOSCO had
recognised the role of regulators in deterring manipulation and unfair trading practices in
its 1998 principles, IOSCO's statement came after the stock market bubble, inflated by this
conflict of interest practice, had burst and many investors had lost their money and
confidence in the stock-market
(see chapter 1).
At the end of 2004, IOSCO announced the plan to press offshore markets to cooperate
better with securities regulators. After frauds at for example Parmalat, the role of offshore
markets in securities markets became apparent, and IOSCO expressed its concern that
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 144
those offshore markets were standing in the way of effective market supervision. Only 1
offshore centre has actually signed the MOU (Jersey) but other offshore centres are
pressed to follow in order to enable information exchange
44
.
The implementation of IOSCO's broad and general principles was left to the national
authorities and the financial industry itself. One measure of implementation was the total
split between activities of securities analysts and investment banking, thus undoing some
aspects of consolidation.
5.3.4 Supervising and regulating all-finanz firms
Each of the above mentioned institutions have tackled some of the problems that
consolidation in the financial industry brings. In addition, the Basel Committee on Banking
Supervision, IAIS and IOSCO established a Joint Forum in 1996. The Joint forum
examines supervisory issues relating to financial conglomerates that combine banking,
insurance and securities activities and that develop new financial services in which the
distinctions between the three activities are blurred (e.g. loans combined with life
insurance and investment in securities).
The work and the reports
45
of the Joint Forum focuses on avoiding instability in the
financial markets and financial industry by:
increasing the understanding the differences and similarities for supervisors of
banking, insurance and securities activities (e.g. outsourcing in financial services
and credit risk transfer),
proposing supervision measures for consolidated firms, and
stimulating cooperation among the relevant supervisors.
The Joint forum has only members of 13 Western countries. The Central banks authorities
of these countries also meet in the Committee on the Global Financial System (see
below).
Most of the official advise on consolidated financial firms given by experts to supervisors
and regulators does not go beyond more cooperation between supervising and regulatory
authorities, swifter action in case of potential crisis, and better information disclosure so
that clients and investors can react when information show flaws in the operation of a
financial conglomerate ("market discipline").
46
Critical issues
No comprehensive response to consolidation strategies
The current international supervision and regulatory mechanisms have not come
up with a comprehensive response to the trends and activities of internationally
operating financial firms although the complexity of not only one financial
conglomerate, but also the interconnectedness and interdependence of financial
conglomerates, is still very difficult to oversee and different scandals indicate that
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 145
financial firms do manipulate markets.
47
They were even not able to form an
integrated international body to regulate and supervise the different worldwide
activities of consolidated financial firms: the Joint Forum falls far short of what is
necessary. Experts and studies by the above mentioned bodies indicate that
supervisors and regulators are still left with important challenges
48
such as:
Uncertainty about the risks of consolidated financial firms. What
seems to be clear, however, is that if a large and complex financial firm
became impaired, than the closing down of such a firm will likely to be
disorderly and have broad implications on the economy.
Uncertainty about the future shape of financial sector consolidation:
consolidation might fully continue leading to a few dominating financial
firms, or outsourcing and/or the creation of specialised financial firms
might give consolidation a particular shape
Unpredictability and uncertainty about the threat to financial
instability: assumptions are that instability is likely to come from
increased transborder and wholesale
49
activities, the swiftness of the
capital moves, the worldwide interconnectedness in particular financial
sub-sectors and the increasing interdependencies between the leading
financial firms (e.g. through interbank loans, credit derivatives).
Insufficient information is published by consolidated banks to their
clients, investors and supervisors, which would enable the latter to see
whether too many risks are being taken.
50
A review of the annual reports
of fifty-four international banks in 2001 showed that they disclosed only
63% of the items considered important by the Basel Committee of
Banking Supervision. While that was an improvement over the previous
years, it was still far from sufficient. In particular, information about their
techniques for mitigating credit risks (including the more speculative
credit derivatives) was lacking, which makes it difficult to monitor from the
outside their practices and expertise for avoiding bad loans, a major
source of (in)stability.
Consolidation does not lead to spectacular increases of efficiency
while the consumers get less favourable conditions and SMEs get less
loans from consolidated firms.
A small number of leading financial firms increasingly dominate
some specific activities, such as investment banks and payment and
settlement services. Such domination might lead to abuse of market
power e.g. higher prices, and to risks to the financial system e.g. if the
payment services were to fail.
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Chapter 5 – Governmental regulations at the international level 146
Continued difficulties to monitor the internal capital flows within a
consolidated bank. Payment and settlement flows increasingly become
between a few parties or in-house transactions.
5.4 Regulation, supervision and decisions related to
capital flows and the international financial system
In addition to standards on how to regulate and supervise the behaviour of financial
services companies, there are international institutions that deal with issues to prevent the
international financial system from collapsing and to ensure stability of international capital
flows and financial markets. As capital flows and financial markets are the instruments of
the financial firms, the themes under discussion and review in these institutions are
sometimes closely related to regulatory and supervisory issues. The institutions described
below deal much more with the wide ranging discussion about the “international financial
architecture” that has regained importance after the Asian financial crisis in 1997-98
because it damaged many economies and citizens of “emerging markets”. It is however
beyond the scope of this report to deal with these institutions and issues in detail.
The discussions about the reform of the financial architecture are organised around the
following issues
51
:
Macroeconomic policy and data transparency:
monetary and financial policy transparency
fiscal transparency
data dissemination
data compilation
Institutional and market infrastructure:
insolvency
corporate governance
accounting
auditing
payment and settlement
market integrity
market functioning
Financial regulation and supervision:
banking supervision
securities regulation
insurance regulation
financial conglomerate supervision
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Chapter 5 – Governmental regulations at the international level 147
5.4.1 International fora for discussing financial system
stability
The issues to prevent an international financial crisis are mostly discussed in the following
important international institutions. A short overview
52
in this report describes these
institutions in short with references that allow further monitoring.
The Financial Stability Forum without enforcement mechanisms
The Financial Stability Forum (FSF) was convened in April 1999 to improve the
functioning of markets and reduce systemic risk. It regularly brings together senior
representatives of financial authorities (e.g. central banks, supervisory authorities and
treasury departments) from 11 financially important countries
53
, 6 international financial
institutions, 7 international regulatory and supervisory groupings, 2 committees of central
bank experts and the European Central Bank. The FSF has no enforcement mechanisms
but proceeds through information exchange, and international cooperation and
coordination in financial supervision and surveillance. During its meetings, it assesses the
state of vulnerability of the international financial sector.
12 Key Standards for Sound Financial Systems
The Financial Stability Forum has highlighted 12 standards as key for sound financial
systems and deserving of priority implementation by all countries. While the identified key
standards vary in terms of their degree of international endorsement, they are
internationally broadly accepted as representing minimum requirements for good practice
and resulting in beneficial effect on the stability of national and international financial
systems. Some of the key standards are relevant for more than one policy area.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 148
Table: Key standards promoted by the Financial Stability Forum
Area Standard Issuing Body
Macroeconomic policy and
data transparency
Monetary and financial policy
transparency
Code of Good Practices on
Transparency in Monetary and
Financial Policies
IMF
Fiscal policy transparency Code of Good Practices in
Fiscal Transparency
IMF
Data dissemination Special Data Dissemination
Standard (SDDS)/
General Data Dissemination
System (GDDS)(1)
IMF
Institutional and market
infrastructure
Insolvency (2) World Bank
Corporate governance Principles of Corporate
Governance
OECD
Accounting International Accounting
Standards (IAS)(3)
IASB (4)
Auditing International Standards on
Auditing (ISA)
IFAC (4)
Payment and settlement Core Principles for
Systemically Important
Payment Systems
Recommendations for
Securities Settlement Systems
CPSS
CPSS/IOSCO
Market integrity The Forty Recommendations
of the Financial Action Task
Force on Money Laundering /
8 Special Recommendations
Against Terrorist Financing
FATF
Financial regulation and
supervision
Banking supervision Core Principles for Effective
Banking Supervision
BCBS
Securities regulation Objectives and Principles of
Securities Regulation
IOSCO
Insurance supervision Insurance Core Principles IAIS
Source of table: http://www.fsforum.org
Notes:
1) Economies with access to international capital markets are encouraged to subscribe to the
more stringent SDDS and all other economies are encouraged to adopt the GDDS.
2) The World Bank is co-ordinating a broad-based effort to develop a set of principles and
guidelines on insolvency regimes. The United Nations Commission on International Trade
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Chapter 5 – Governmental regulations at the international level 149
Law (UNCITRAL), which adopted the Model Law on Cross-Border Insolvency in 1997, will
help facilitate implementation.
3) Relevant IAS are being reviewed by the IAIS and IOSCO.
4) The International Accounting Standards Board (IASB) and the International Federation of
Accountants (IFAC) are distinct standard-setting bodies in that they are private sector
bodies.
Committee on the Global Financial System (CGFS)
54
is a forum of the rich
The CGFS, composed of the Central Banks of 13 rich countries, undertakes:
systematic short-term monitoring of global financial system conditions,
longer-term analysis of the functioning of financial markets, and
the articulation of policy recommendations aimed at improving market functioning
and promoting stability.
It has developed a list of general principles and more specific policy recommendations for
the creation of stable securities markets. It has set up a Working Group on incentive
structures in institutional management. The Working Group published a report in March
2003 about the evolution of the asset management industry (e.g. mutual funds, pension
funds, insurance companies) and its impact on financial stability, as it is a financially
important sector.
International Monetary Fund (IMF)
55
more active on financial crisis prevention
The work of the IMF is of three main types.
1. Surveillance that involves the monitoring of economic and financial developments,
and the provision of policy advice aimed especially at crisis-prevention.
2. Lending to countries with balance of payments difficulties, providing temporary
financing and supporting policies aimed at correcting the underlying problems; loans
to low-income countries are also aim at poverty reduction but include harsh
conditionality based on free market policies.
Technical assistance and training in areas of IMF expertise.
Supporting all three of these activities is the IMF's work in economic research
and statistics.
The International Financial Committee that meets at the bi-annual meetings of the IMF
attended by most Ministers of finance have been a key forum to take decisions, or
obstruct decisions, on measures for the reform of the international financial architecture.
A major problem is the lack of proper voting rights by developing countries, which is now
being discussed with little progress.
Since the financial crisis of 1997-98, the IMF's work has more focused on crisis
prevention. It improved the availability of important information (e.g. levels of countries’
external debt, financing in emerging markets) and publishes twice a year the Global
Financial Stability Report. In collaboration with other standard-setting bodies, it has
developed international standards for data dissemination and transparency practices in
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Chapter 5 – Governmental regulations at the international level 150
fiscal, monetary and financial policies, and has contributed to the development of
international standards for banking supervision.
The IMF has together with the World Bank implemented the Financial Sector Assessment
Programme - FSAP which identifies strengths and vulnerabilities of a country's financial
system and helps to deal with the latter. Under the programme, country reports are
prepared with information on how a country implements financial standards and codes of
best practice. In these country reports, the IMF also looks at the state of the financial
industry and seems to favour consolidation of the financial industry at national level. In a
report on the German banking system, the IMF called for a modification in banking
regulations to allow merger processes that would do away with state owned banks and to
accelerate consolidation in the sector.
56
The Financial Sector Reform and Strengthening
(FIRST) Initiative is a US$ 53 million multi-donor program, supporting capacity building
and policy development projects in the financial sectors in developing countries.
In its normal lending and advisory activities, the IMF is now much less insisting on (full)
liberalisation of capital flows (capital account liberalisation) as it did before the Asia
financial crisis. Too swift liberalisation of capital flows is increasingly recognized as
contributing to financial crises.
As part of the Offshore Financial Centres Assessment Programme, IMF staff undertakes
detailed assessments of the extent to which offshore financial centres meet the standards
advocated by the international standard-setting bodies. It assesses any further action
required to meet these standards such as technical assistance. It also collaborates with
standard-setters and supervisors to strengthen standards.
The Organisation for Economic Cooperation and Development (OECD)
57
has
unfamiliar code to liberalise capital flows
In general, the OECD promotes policies and efficient functioning of markets to achieve
economic growth and employment in its member countries.
58
It encourages the
convergence of policies, laws and regulations covering financial markets and enterprises.
The OECD division on finance and investment stimulates discussions on the many
issues related to finance and investment. It publishes an annual report with data and
trends about the profitability and health of the banking systems in 30 OECD countries.
59
The OECD division on insurance and pensions is equally a forum to discuss and study
issues and problems in those respective sectors. It includes the OECD Insurance
Committee and the Group of Governmental Experts on Insurance Solvency.
The OECD Code of Liberalisation of Capital Movements came into force in September
1961 and was regularly updated, lately in January 2003. This Code has played a very
important role in liberalizing capital flows, however this has gone unnoticed. Such
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 151
liberalisation of capital flows allowed financial firms to expand their international activities
without restrictions on their international capital movements.
The Code contains obligations for OECD members to liberalise capital flows related
to:
direct investment (FDI),
securities (includes portfolio investment),
services,
loans,
insurance,
foreign exchange,
payments for imports and exports, and
personal capital movements.
It is based on principles such as non-discrimination between capital flows from OECD
members, transparency and exceptions to liberalisation (e.g. in the case of financial
problems).
Although the code is legally binding for OECD members it is not a treaty under
international law. The ultimate decisions on its monitoring and application lie with the
OECD Council. New members have to abide by the code but can be exempted from some
obligations for some time to avoid financial disturbances. Implementing the Code has had
an important impact on helping create the South East Asian financial crisis because it
pressed its new member South Korea to remove restrictions on financial flows, which
allowed risky, volatile and uncontrolled financial flows before and during the financial
crisis.
Action against money laundering and tax evasion by the Financial Action Task
Force on (FATF)
60
and OECD
The FATF, established in 1989, has set out a programme of forty "Recommendations" to
combat laundering money from corrupt and criminal activities. The recommendations were
updated in 1996 and again in 2002 in the wake of the 11 September 2001 terrorist attacks
against the U.S., when 8 Special Recommendations were added to the original forty. The
FATF monitors the progress by its 26 members in implementing measures to counter
money laundering, reviews money laundering trends, techniques, and counter-measures,
and promotes the adoption and implementation of the FATF Recommendations by non-
member countries.
The FATF is based at the OECD that also attempts to deal with offshore centres because
they facilitate money laundering and tax evasion, resulting in tax competition harming
OECD countries. Many countries with tax havens and offshore centres have reacted
disapprovingly to the OECD. While improving some of their regulatory oversight, they
resist amending their low taxation policies. The Caribbean countries threatened to use the
WTO when the US, Canada and Japan warned their financial firms to be wary of doing
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 152
business with he Caribbean offshore centres. The latter considered these warnings as
restrictions on trade in financial services with those centres.
61
The exclusive G-7 and some input by developing countries in the G-20
Since 1986, decisions about exchange rates and international financial stability have for
an important part been taken by the Finance Ministers of the Group of Seven richest
countries in the world (G-7: Canada, France, Germany, Italy, Japan, UK, US). Russia
joined the G-7 (G-8) and attends most meetings of the G-7 meetings of finance ministers.
This exclusive and non-transparent informal forum has been discussing many important
issues that were also being discussed at other fora dealing with financial stability. It
recently played an important role during the financial instabilities that started in 2001 after
the September 11 attacks and the fall of the stock market. The financial reserves of banks
and insurers that had invested in shares were dropping dramatically and the G7 leaders
took the decision not to pressure banks and insurance companies to keep up the required
reserves. Otherwise these financial firms would have been forced to sell their low-valued
shares for other financial assets, resulting in massive sales of shares, which would have
further decreased the value of equities at the stock market. Moreover, the Central banks
decided to intervene by lowering interest rates and providing massive extra credit to the
commercial banks.
62
When the G-7 takes a decision to introduce a measure, or to intervene in the major
exchange rates, this has wide ranging effects on other countries who have no say in the
forum. Because the so-called “emerging markets” have the last two decades plaid an
increasingly important role in financial flows and financial crises, the G-7 has decided to
convene a Group of Twenty (G-20) to discuss issues of global financial stability between
the G-7 countries and other countries with important financial flows or financial risks such
as Argentina, Australia, Brazil, China, Mexico, Saudi Arabia, South Africa, Korea and
Turkey.
5.4.2 State of the reform of the international financial system
Good ideas, little reform
The various fora mentioned above have identified and discussed many issues to avoid a
financial crisis by misbehaviour of governments and the financial industry. On the one
hand, standard setting for better regulation and supervision has progressed and the
situation in developing countries has improved through technical assistance and
monitoring programmes. Cooperation between different authorities, nationally and
internationally, also made progress. On the other hand, many of the standards deal with
past crises and only tackle issues that might lead to a financial crisis in the future. Some
standards were developed after damage has been done (e.g. IOSCO did not prevent
conflict of interest in securities trading).
Overall, real progress in applying the necessary restructuring measures is absent. In other
words, many good ideas but little reform. Introduction of new measures to reform the
international financial architecture has bogged down after an insolvency regulation for
sovereign debtors (states) was removed from the agenda at the 2003 Spring meeting of
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Chapter 5 – Governmental regulations at the international level 153
the IMF. However, the quick steps taken against money laundering and bank secrecy after
the 'September 11' attacks indicate that swift reforms in the financial architecture are
possible if there is enough political will to do so.
Many challenges left for developing countries
For developing countries the following important problems in the financial system are still
not solved. In case of a new financial crisis, their population and economies are likely to
have to carry the burden of the devastating effects. The financial crisis in Argentina and
Turkey are a case in point. Unresolved problems are:
Instability of capital flows
There is a political unwillingness, supported by the financial industry -and vice versa-, to
restrict the billion of dollars flowing daily across borders through financial firms and
financial markets for speculative and short term profit making. The discussions to
introduce capital controls such as a “tobin tax” have made little progress. Most worryingly,
the instruments used by governments to control and slow down cross-border capital flows
are being taken away in trade agreements (e.g. during the negotiations for a bilateral trade
agreement with Chile, the US pushed hard to remove the “Chile tax” which is
internationally recognized as an important financial stabilization instrument). There is little
political will to prohibit financial products from financial firms that are highly speculative
and create uncertainty, such as credit derivatives. Still, short term capital flows are
prioritised due to the Basel II accord (see 5.3.1).
No solution to a potential “moral hazard”
In the past, banks and other financial actors that undertook too risky operations that
resulted in bankruptcies had to be bailed out by governments in order to avoid total
destabilization of the financial system and the economy. In other words, taxpayers’ money
was used to cover the debts and losses of commercial and speculative financial actors. At
present, there has been made some improvement by adopting collective action clauses
(CAC’s) in the issuance of government bonds under New York law. These clauses state
that in case a government, which has issued bonds, is in financial stress, and a majority of
bondholders agrees to restructure the conditions (e.g. the payment terms) of the bonds
issues, a minority of bondholders can no longer block this process. In the recent past,
bondholders have often take legal action to make states (i.e. taxpayers) repay their
investments whatever the situation in the country. It is the question whether the
introduction of CAC’s will have a real impact: their use is still voluntary under New York
law, and normally it still takes 75% of all bondholders to agree on a restructuring.
There is no lender of last resort where governments can obtain temporary funds without
(the wrong) conditions attached to solve a financial crisis due to misbehaviour of the
financial industry. The current contingency credit line of the IMF is not functioning well as
countries are afraid to use it.
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Chapter 5 – Governmental regulations at the international level 154
Continued high debts in foreign currency by developing countries result from
insufficient international debt cancellation mechanisms and unfair arbitration mechanisms
to cancel or restructure governmental and commercial debt .
There is still quite some instability of exchange rates that damages income to
developing countries as can be witnessed by the lowering value of the US Dollar
compared to the Euro during 2003. At the same time fixed exchanged rates (e.g.
pegging the value of a national currency to the value of the US Dollar), which caused the
financial crisis in Asia, is still being used for instance by China that has been building up a
huge reserve in US Dollars, much to the dismay of the US. What kind of exchange rate
mechanism is the best?
Lack of information and understanding (models) to predict the next financial crisis,
even in Western countries. For instance, there is no internationally publicly available
information about all currency transactions of one particular bank.
New complex financial products, new technology, and new management techniques
accompanying continuous expansion abroad by consolidated financial firms still
poses unknown risks of financial instability and economic, social and environmental
effects. Recently, banks started to use complex financial products that transfer the credit
risks to others, for instance through securitization of (bad) loans and derivatives. This
makes it unclear who ends up taking the risk of bad debt (in any case not the bank that
provides the credit). Currently supervisors are afraid of unchecked, concentrated
accumulation of credit risk.
63
New important reforms such as the reform of the Basel Capital Accord (Basel II) take
much longer than foreseen to agree upon and are seen in the interest of large
international banks. The negative effects of Basel II on banks and provision of credit in
developing countries is still hardly heard (see above).
Many developing countries give priority on macro-economic and financial sound policies
that should keep investors happy, even if these investors are speculative or portfolio
investors. At the same time, social and environmental needs of the population are being
sacrificed.
Increasing importance of offshore centres
Offshore centres facilitate tax evasion and capital flight from developing countries through
low tax rates and lax monitoring rules. In 2003, the importance of offshore centre activity
increased with recorded claims on offshore centres totalling US$1.8 trillion in the second
quarter of 2003.
64
The huge budget, current account and trade deficit of the US is being financed by
issuing governmental bonds (mostly bought by Asian central banks such as Japan and
China), rules that make transferring money to the US attractive (foreigners do not need to
pay tax on interests in the US), and the strong investment banking and securities services
firms that dominate globally.
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Chapter 5 – Governmental regulations at the international level 155
Important role of the financial industry lobby
The successful lobbying of the financial industry plays an important role slowing down the
regulatory reforms of the international financial system. The financial sector regularly
dialogues with the authorities lobbying against new regulations and intervention. The
financial industry says that if the authorities create one rule, escape routes and new
problems will be created.65 The sector also argues that complying with a lot of regulations
is too expensive, which would cut deep into their profits.
The financial industry and investors are still hoping that, during the next financial crisis,
they will be able to much better defend their own (short term) interests without
international rules that would share the burden of a financial crisis.
The Institute for International Finance (IIF
66
) is an important lobby that represents the
major global financial firms and intervenes in many of the above-mentioned fora. The IIF
has openly argued against international measures that would prevent bailouts by
governments and would share the financial burden when governments cannot repay their
debt. In 1999, it declared that financial firms had the sole responsibility to increase
shareholder value and create profit while it was the responsibility of the government to
create financial stability and promote social objectives.
67
Such corporate lobbying influences and reinforces the neo-liberal thinking of governments
and financial authorities. As a result, many financial regulatory and supervisory authorities
in the Western countries are reluctant to introduce measures that would intervene in the
free market. The lack of support by the US often hinders new international measures to be
taken, for instance on the insolvency regulation for debtor states. The US position is
heavily influenced by the lobby of its financial sector industry that dominates world
markets in many sub-sectors of the financial services.
Even at the UN Conference on Finance for Development (Monterrey, Mexico, 2002) all
efforts to introduce issues of restructuring the financial system for development goals have
been undermined by the US and other Western countries.
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Chapter 5 – Governmental regulations at the international level 156
Critical issues
The lack of reform in the international financial architecture provides global
financial firms ways to escape sharing the burden of a financial crisis they might
help create. In case of a global financial crisis, the poor citizens and developing
countries are still too unprotected.
The current system of improving international coordination, cooperation and non-
binding standards seems so far to be working to avoid a world wide financial
crisis. However, the insurance industry and the stock market were causing
serious threats to financial stability in Western countries up to beginning 2004.
The pension crisis was still not resolved by the time of finalizing this report (March
2004). Developing countries in financial problems, such as Argentina, have not
been helped by the many foreign banks present in their country nor been brought
to quick economic recovery by the intergovernmental financial institutions.
5.5 Relation of financial services with auditors
Banks and other financial firms that provide financial services to companies rely heavily on
the financial reports of companies in order to assess the financial health of a company.
These financial reports are provided and checked by auditors, who thus play an important
basic role. There are, however, no auditing rules yet that are internationally enforceable
but there are international standards that are being adopted and implemented, sometimes
through national or EU law.
Since 2001, the accounting industry has been under much criticism for not being able to
detect fraud and other practices that lead to the financial collapse of multinationals such
as Enron and Parmalat. For instance, based on the wrong public financial reports from
accountants about Parmalat, some 20 investment banks were involved in 40 bond issues.
They raised around $ 9 bn for Parmalat in 10 years from large and small investors. Those
who bought Parmalat bonds for covering their pension might never see their money
back.
68
Holders of Enron shares and bonds started a class action litigation because Citigroup
mislead investors and helped hide Enron’s debt. In June 2005, Enron agreed to pay $ 2
bn to settle the case.
As part of the efforts to create a European single market, the European Commission
aimed to make all 7 000 firms listed in European exchanges use the same accounting
standards. The standards were designed by the International Accounting Standards Board
(see below) and are called the International Accounting Standards (IAS) & Financial
Reporting Standards (IFRS). In 2003 and 2004, there was much discussion about the 41
draft standards published by the IASB. Especially the IAS39 was heavily debated. This
rule covers accounting of financial instruments like derivatives. It states that those
instruments should be valued at ‘fair value’ (current value) instead of ‘historic value’. Since
fair values are much more volatile than historic ones, the balances of many financial firms
would also show much more volatility.
69
Obviously, financial firms have heavily opposed
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Chapter 5 – Governmental regulations at the international level 157
the proposals. The EU financial industry put heavy pressure to make new reporting more
suitable to their interests.
70
From January 2005 onwards, use of the standards has been made obligatory.
International standard setting on accounting and auditing takes place at:
International Accounting Standards Board (IASB): The IASB is a privately funded
accounting standard setter based in London. Board members have a variety of functional
backgrounds from nine countries. They aim at developing a single set of high quality,
understandable and enforceable global accounting standards that require transparent and
comparable information in general financial statements. In addition, the board cooperates
with national accounting standard setters to achieve convergence in accounting standards
around the world. The IASB is responsible for developing and approving the International
Accounting Standards (IAS).
http://www.iasc.org.uk
International Auditing and Assurance Standards Board (IAASB): The IAASB is a
committee of the International Federation of Accountants (IFAC) that works to improve the
uniformity of auditing practices and related services throughout the world. Therefore, it
issues pronouncements on a variety of audit and assurance functions and promotes their
acceptance.
http://www.ifac.org
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Chapter 5 – Governmental regulations at the international level 158
5.6 Conclusions and critical issues
1. Standards not internationally binding
Different international financial bodies set standards to regulate and supervise the various
activities of the financial industry. They provide guidance for regulators and supervisors
who are encouraged to implement the standards at the national level.
The international financial standards are not legally binding by international law nor
enforced through international mechanisms. Adoption of the financial standards by
national financial authorities around the world depends on cooperation, exchange of
information, and 'peer pressure' or name and shame. The regulatory and supervisory
framework is therefore different in each country. At international level, there is no
minimum of binding rules that regulate all operations of international financial firms in all
countries.
Because the standards are not binding, some governments chose not to adopt high
standards to prevent tax evasion in order to encourage their financial industry and markets
to compete internationally. Such offshore centres manage 40% of the world's wealth.
2. Regulation and supervision of the consolidated financial industry is
insufficient
The current international and national supervision and regulatory mechanisms have not
devised a common view or comprehensive response to the swift developments of the
cross-category and cross-border consolidation by global financial firms. Mega
conglomerates, like Citigroup, are becoming too big to fail. Governments cannot afford to
let them collapse because the effects on the wider economy would be devastating, even
though the costs of intervention and insuring clients are high.
National coordination and integration of supervision on banking, insurance and securities
activities is still unsatisfactory in many countries to supervise cross-category
consolidation. Each country is setting up different systems and has different policies
towards consolidation, which hampers effective international coordination to handle
problems facing complex and internationally operating financial conglomerates.
At the international level, there is no oversight of all the transactions for each financial
mega conglomerate separately, which means that no one body can fully assess the risk of
such potentially volatile financial players. Even the Joint Forum, which was created
especially to deal with conglomerates, does not have an urgent strategy on cross-sectoral
and cross-border financial supervision and regulation. The current lack of cooperation
between home country authorities and developing countries supervisors might hamper a
comprehensive response across boarders to deal with a conglomerate collapse.
3. Too little too late
International financial bodies have improved cooperation between national supervisors
and regulators, especially among national bank supervisors as a result of the work of the
Basel Committee. However, they do not follow the speed of the financial industry
developments and expansion into developing country markets. Progress is too slow,
especially in the insurance sector. Some standards and guidelines have only been created
when the damage was already done by a major crises or corporate scandal (e.g. the
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Chapter 5 – Governmental regulations at the international level 159
Basel Core Principles, IOSCO on conflicts of interest). International banking statistics
have also improved after each crisis and financial instability threat.
At the same time, progress in strengthening the financial architecture has been bogged
down and stalled by the lobby of the major financial services sector, leaving the system
even more vulnerable.
4. Developing countries lack the right to be heard, but are expected to comply
Many international standard setting bodies have no or little participation from developing
countries, although 'emerging markets' are often consulted and targeted. The main
decisions about capital flows and stability of the financial markets are still taken by bodies
where developing countries have no real say (e.g. G-7, IMF) and where problems of
developing countries are not sufficiently addressed.
5. Supervisors and regulators fail to adequately deal with risk
The so-called independent regulatory and supervisory authorities are beginning to rely
heavily on the financial firm’s own risk management procedures. This trend will
dramatically increase when new, controversial, rules on assessing borrowers ('Basel II')
will be finalized (due by mid 2004).
6. The lack of political will to prevent any financial crisis happening
Complacent about the prospects of a new financial crisis, officials and financial experts are
reluctant to intervene in the market even if the consequences are grave for many who are
already poor. Supervisors and regulators are under constant pressure from the financial
industry and its lobby.
The international financial supervisory and regulatory bodies are ignoring the risks of too
swift increase in unequal and unfair competition between foreign and domestic financial
firms due to liberalisation of financial services. The negative consequences cannot always
been dealt with through national regulation and supervision.
7. Civil society concerns ignored
The financial industry’s powerful voice heard at the international standard setting bodies
contrasts dramatically with the voice of civil society groups, which is barely, if ever, heard.
The work of international supervisory and regulatory bodies is not transparent and to date
has no system to involve all stakeholders. Public debates do not precede important
decisions taken at those institutions.
Regulators and supervisors at international level have little interest in environmental or
social issues, but rather in “maintaining a stable financial environment“ and avoiding
bankruptcies. Drafting of new banking supervision rules ('Basel II') did not incorporate risk
assessment from a sustainable development perspective. The many international fora
dealing with financial instability seem to be hugely underestimating the risks and costs
from environmental degradation, climate change and unfair globalisation that marginalizes
the poor.
Consequently, there are no international regulations that compel the financial industry to
support international agreements to eradicate poverty, and to promote sustainable
development and corporate social responsibility. No wonder there is not enough money
for sustainable development and CSR issues; all mainstream financial instruments have
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Chapter 5 – Governmental regulations at the international level 160
no binding obligation to prioritise sustainability: not in savings, credit, investments, or
insurance.
8. International financial bodies need to widen their scope
Leaving the negative social and environmental effects of international financial sector
consolidation and competition to national legislators and supervisors to deal with, is
inappropriate. Protecting consumers, marginalized people and the environment becomes
too complex and too costly, especially for many developing countries. International
competition might put pressure on governments not to introduce new high standards.
Moreover, many financial firms still see it as the responsibility of governments to achieve
financial stability and societal objectives, while they prioritise profit making and increasing
shareholder value. Current international financial operations and competition require
international financial bodies and free trade negotiators (see chapter 6) to tackle the
problems collectively. Financial authorities could do a lot at national and international level
to redirect financial flows towards more sustainable activities through for instance
71
:
new regulations on risk assessment, access and quality of services, and
obligations to report and inform about ethical policies;
new rights and obligations for investors, investment managers, governmental
financing institutions and shareholders;
tax incentives;
subsidies and other policies to promote sustainable financial products;
radical eradication of tax havens and bank secrecy,
more leeway for alternative financing schemes.
Civil society groups will have to find new ways to dialogue with international regulatory
and supervisory bodies in order to widen the latter's scope. They will also have to raise
awareness among the public about these complex issues to boost public debates and
support.
9. This report does not cover the many alternatives that have been conceived and
developed in order to avoid the problems of the corporate driven financial sector. These
alternative money systems are often used in times of crisis, as in Argentina, when
authorities have failed, money is scarce and credit once offered by financial firms has
dried up.
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Chapter 5 – Governmental regulations at the international level 161
5.7 Sustainability and Accountability in the Financial
Services Sector Regulatory and public policy
recommendations
The following paper was released by Friends of the Earth – US concurrent with the launch
of the Collevecchio Declaration (January 2003). The Declaration calls on financial
institutions to support regulatory changes that make it more possible for the financial
sector to advance sustainability.
Governments can and must play a key role in creating public policies and regulatory
frameworks that increase the ability of the financial services sector to advance
sustainability. In addition, governments must also improve accountability from the financial
services sector itself, as a way of ensuring that financial institutions are responsive to the
needs and expectations of the public.
Increase the ability of financiers to advance sustainability
As market makers and allocators of capital, financial institutions have a unique role and
responsibility in advancing sustainability. Financiers can:
Integrate environmental and social objectives into their financial strategies;
Analyze the social, environmental, or development impact of potential
transactions;
Use their influence and price capital in ways that promote sustainable practices
among their clients and investments;
Proactively finance enterprises that reduce poverty, enhance equity and restore
the environment.
However, financial institutions are often limited in their ability to implement these practices
because of current laws, and because avoiding certain types of transactions can put
responsible financiers at a competitive disadvantage compared to their more
unscrupulous competitors. Also, faced with imperfect markets, financiers find it "cheap to
do bad things, and expensive to do good things" because the costs of environmental
degradation and ill public health are often externalized onto the general public. Such
barriers can only be overcome by governmental action.
A. Integrating environmental and social objectives into financial strategies
Governments can take the following actions to help financiers align environmental and
social objectives into financial strategies and decision-making:
Changing the definition of fiduciary responsibility: In many countries, strict
interpretations of "fiduciary duty" discourages investment managers and trustees
from examining the social, economic and environmental dimensions of their
investment choices. Regulators should clarify that consideration of environmental,
economic and social issues is not in violation of, and in fact could advance the
fulfilment of, fiduciary duty. Governments can also expand the definition of
fiduciary duty to include the broader well-being of beneficiaries.
Public investment policy: Government regulators should create socially and
environmentally responsible investment policies and objectives for public finance
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Chapter 5 – Governmental regulations at the international level 162
agencies and governmental retirement funds. For example, public export credit
agencies should adhere to high universal environmental and social standards,
and require co-financiers (e.g. loan syndicate partners and recipients of loan
guarantees) to do the same.
B. Analyzing the social, environmental, or development impact of potential
transactions
In order to implement investment, credit, or underwriting policies that promote
sustainability, financiers must have access to information on a potential transaction's
social or environmental impact. In particular, investors need comparable and robust social
information for all companies their investing universe.
Corporate disclosure laws: Governments should implement corporate social and
environmental disclosure regulations in markets around the world. Environmental
and Labour Ministries should create disclosure laws that obligate companies to
report data such as toxic releases, or worker health and safety data. For example,
in the United States, the Community Right to Know Act requires companies to
disclose toxic releases in a national Toxic Release Inventory.
Securities disclosure laws: National securities disclosure laws should require
reporting of material environmental, social and other corporate responsibility data.
For example, France currently requires disclosure of key environmental and
worker health and safety data in company annual reports.
Protection of civil rights: In order to perform adequate due diligence about the
social, environmental, or economic impacts of a potential transaction, financial
institutions often rely on civil society organizations as a source of information,
particularly in markets where disclosure regulations are poor. Therefore,
governments should support the preservation and promotion of civil and political
rights and freedoms around the world, particularly in developing countries.
International securities and accounting standards: The International Accounting
Standards Board and the International Organization of Securities Commissions
are currently working to harmonize corporate accounting and disclosure
standards across major markets. The IASB and IOSCO should ensure that best
practice in environmental and social financial accounting are promoted.
C. Using influence and pricing capital in ways that promote sustainable
practices among their clients and investments
The following public policies could increase the ability of financiers to use their unique role
as company shareholders and providers of capital in ways that promote sustainability:
Shareholder rights laws: Shareholder rights are in part defined by state or national
securities and/or company laws, which delineate the requirements for filing
shareholder proposals for both domestic and foreign investors, including topics
which are considered appropriate for shareholder action. For example, securities
laws in the United States provide relatively strong rights to investors by allowing
smaller shareholders to submit proposals, and by providing a degree of
supervision from the Securities and Exchange Commission when companies and
shareholders disagree about the appropriateness of a proposal.
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Chapter 5 – Governmental regulations at the international level 163
Incentives for sustainability: Regulators can create incentives for financial
institutions to capitalize environmentally/ social beneficial enterprises, and for
activities that generate income for the poorest. For example, the Netherlands has
introduced tax-free green funds (exempt from interest and dividend income tax) to
encourage Dutch citizens to invest in environmentally beneficial projects. Other
incentives could include giving banks a small degree of flexibility in their capital
adequacy requirements in return for prioritizing sustainable investments. The new
Basel Capital Accord ("Basel II") could also integrate sustainability factors into its
new methodology for evaluating banks' risk.
D. Proactively financing enterprises that reduce poverty, enhance equity and
restore the environment
Financiers often find it difficult to practice "community investing," financing enterprises that
reduce poverty, enhance equity and/or restore the environment. For example, financiers
can provide direct financing for socially and environmentally sustainable ventures,
purchase debt instruments in community development or micro-enterprise loan funds, or
finance low-income housing, small, women- or minority-owned businesses.
Bank regulation: Requiring commercial banks to lend to economically distressed
areas may help create markets, institutions and financial products that promote
community investing. United States example: The US's Community Re-
Investment Act requires commercial banks to target a certain portion of their
portfolio to investment opportunities in the bank's local economy, especially those
consumers that are historically disenfranchised. Banks are also ranked on their
compliance with the Act. The CRA has helped create an entire sub-sector of
community development financial institutions in the United States, which
specialize in providing access to capital and credit to low-income and distressed
communities. Similar regulations could also be applied to investors such as
collective investment schemes.
Protect community investing from trade agreements: Common trade-related
investment measures may harm the existence or effectiveness of community
development financial institutions. For example, provisions for "national
treatment" forbid governments from establishing or maintaining some investment
preferences to promote development in impoverished or minority areas. The
"national treatment" provision could nullify banking laws in the Philippines that
reserve rural banking services to indigenous financial institutions, which often
have particular capacities to serve the rural poor. Similarly, the US's Community
Re-investment Act conditions the opening of new bank branches on a company's
community re-investment record; this could be challenged under the investment
agreements to the WTO.
Capitalize community investment vehicles: National and state governments can
help capitalize community development financial institutions. For example, in the
US, the Community Development Banking and Financial Institutions Act of 1994
created a fund to promote economic revitalization and community development by
investing in and assisting community investment financial institutions through
equity investments, capital grants, loans and technical assistance.
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Chapter 5 – Governmental regulations at the international level 164
E. Minimizing Externalities and Market Distortions
In many cases, financiers are limited in their ability to shift their portfolios in ways that
capitalize enterprises with superior environmental or social performance because those
opportunities are not competitive given current market distortions.
Stronger and better enforcement of environmental and social laws: Where there
are lax or weak enforcement of environmental and social laws, there are fewer
monetary sanctions or impacts for companies with poor social and/or
environmental performance. Strong and well-enforced environmental and social
laws can help send the right market signals to investors.
Provide the right financial incentives: Aligning governmental subsidies,
procurement and tax policy to create financial rewards for responsible corporate
behaviour/ activities and disincentives for environmentally or socially harmful
corporate behaviour/activities can help the stock market reflect the bottom-line
benefits of corporate social responsibility. However, the ability of governments to
align procurement policies with environmental, social or other public policy
objectives may run afoul of "expropriation" provisions in international trade
agreements.
Create market imperatives: Government policies and sectoral objectives often
create markets in and of themselves. For example, in Germany, France and other
European countries, national authorities have committed obtain a certain
percentage of its country's energy from renewable sources. Such targets and
timetables create market imperatives that enhance the ability of financiers to set
and meet their own goals for shifting their energy portfolio into more renewable
investments.
F. Governance and Accountability in the Financial Services Sector
Currently, financial institutions are not held accountable for the downstream
environmental, social and public health impacts of the transactions they finance. Similarly
on the "upstream" side, small savers rarely have a to have a voice in the investment,
credit, and underwriting practices of the institutions that manage their savings and
investments.
Increase lender liability: In most countries, lenders generally are not held liable for
the environmental and social impacts caused by client misconduct. However, as
long as lenders remain financially shielded from the environmental and social
liabilities of their corporate clients, they will not fully value environmental and
social issues when performing their due diligence and pricing capital.
Crack down on predatory lending: In some markets, financial institutions engage
in "predatory lending" practices which banks aggressively sell inappropriate loans
designed to exploit vulnerable and unsophisticated borrowers. Regulators should
pass and enforce strict laws designed to abolish such exploitation and sanction
predatory lenders.
Disclosure in and of investment products: In order to inform consumers in their
choice of managed investment products, consumers need to know the ethical
policies and impacts of such funds. Laws requiring the disclosure of a fund's
ethical investment policies, proxy voting policies and practices, and even portfolio
holdings can assist consumers in choosing or benchmarking investment products.
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Chapter 5 – Governmental regulations at the international level 165
In the United Kingdom, recent law requires pension funds to disclose their ethical
investment policies and practices, if any.
Democratizing investment funds: Governments should promote greater
democracy in investment funds, including governance practices that provide for
better participation of fund participants or beneficiaries. For example, new laws
could oblige pension funds to elect a portion of their trustees from among their
beneficiaries, or require mutual funds to integrate participant input into proxy
voting policies.
Contact: Michelle Chan-Fishel, Friends of the Earth – US; [email protected]
1
Group of Ten, Report on consolidation in the financial sector, January 2001, p. 3.
2
H. Onno Ruding, The transformation of the financial services industry, Financial Stability Institute (Bank
for International Settlements), Occasional paper nr 2, March 2002, p.17 -22.
3
P. Norman, An EU call for transatlantic dialogue, in FTfm, 8 December 2003.
4
See R. Pozen, M. Draghi, A duet to mend markets and heal the rifts, in FT, 7 November 2003.
5
See for instance: C. Kirkpatric, Finance matters - Financial liberalisation: too much too soon?, id21
insights, nr 40, March 2002 (www.id21.org/insights/)
6
H. Onno Ruding, The transformation of the financial services industry, Financial Stability Institute (Bank
for International Settlements), Occasional paper nr 2, March 2002, p. 18.
7
S. Jung-a, KDB to lead joint takeover of LG Card, in FT, 3-4 January 2004.
8
See for instance J. Chaffin, A Michaels, Donaldson warns against turf wars, in FT, 10 September 2003
9
According to BIS (BIS paper nr. 16), offshore centres are: Aruba, Bahamas, Bahrain, Barbados,
Bermuda, Cayman Islands, Hong Kong, Lebanon, Macau SAR, Mauritius, Netherlands Antilles,
Panama, Singapore, Vanuatu; according to other sources and institutions, Switzerland, and Jersey and
other UK small island tax havens are also described as offshore centres.
10
BIS, The international banking market, in Quarterly review, December 2003, p. 16.
11
T. Catan, S. fidler, Swiss court convicts Abacha launderer, in FT, 22 December 2003.
12
Friends of the Earth - US, Sustainability and Accountability in the Financial Services Sector -
Regulatory and public policy recommendations, paper was released by Friends of the Earth - US,
Davos, January 2003.
13
For instance: investment banks can also trade securities in competition against stock exchanges
14
P. Norman, Parmalat changes mood in Brussels, in FTfm, 9 February 2004.
15
Anguilla, Antigua and Barbuda, Dominica, Grenada, Montserrat, St Kitts-Nevis, St Lucia, St Vincent
and the Grenadines, Turks and Caicos islands.
16
Information for this overview is mostly taken from the overview made by the Financial Stability Forum
(www.fsforum.org)
17
For more information see: www.bis.org
18
The list of members are: Algeria, Argentina, Australia, Austria, Belgium, Bosnia and Herzegovina,
Brazil, Bulgaria, Canada, Chile, China, Croatia, the Czech Republic, Denmark, Estonia, Finland,
France, Germany, Greece, Hong Kong SAR, Hungary, Iceland, India, Indonesia, Ireland, Israel, Italy,
Japan, Korea, Latvia, Lithuania, the Republic of Macedonia, Malaysia, Mexico, the Netherlands, New
Zealand, Norway, the Philippines, Poland, Portugal, Romania, Russia, Saudi Arabia, Singapore,
Slovakia, Slovenia, South Africa, Spain, Sweden, Switzerland, Thailand, Turkey, the United Kingdom
and the United States, plus the European Central Bank.
19
The 13 countries are: Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands,
Spain, Sweden, Switzerland, United Kingdom, and United States.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 166
20
The "Principles for the supervision of banks' foreign establishments" of May 1983 replaced the
Concordat's text of 1975.
21
IMF, Managing Risks to the International Banking System, in Finance and development,
December1996, p. 26; see N. Tair, BCCI ‘tragedy’ awaits long run, in FT, 12 January 2004: The UK
supervisors are in 2004 being taken to the court more than 10 years after BCCI collapsed.
22
"Information flow between banking supervision authorities", April 1990: produced by the Basel
Committee in collaboration with the Offshore Group on Banking Supervision.
23
IMF, Managing Risks to the International Banking System, in Finance and development,
December1996, p. 26-27.
24
See for instance M. Vander Stichele, De toenemende rol van banken in het financiële systeem,
October 2000, p. 12.
25
A. Persaud, The Basel plan must get back to market basics, letter to the Editor of the FT, 3 September
2003.
26
C. Pretzlick, Fed tries to safeguard Balse bank reform plan, in FT, 3 December 2003.
27
Basel Committee, Basel Committee Publications No. 109, July 2004
28
Martina Metzger, Basel II - Benefits for Developing Countries, BIF Working Paper Nr. 2, 2004.
29
BIS, High-level principles for cross-border implementation of the new Basel Capital Accord, press
release, 18 August 2003; see “The Set of principles for cross-border application of the New Accord”
(BIS, August 2003).
30
There are many critiques being written about the Basel II draft; they are mainly based on arguments
put forward by M. Metzger, Basel II - Benefits for developing countries?, speech given at WEED
conference, Berlin 29 November 2003; S. Griffith-Jones, How to prevent the new Basel Capital Accord
harming developing countries?, paper presented at the IMF-World Bank Annual Meetings at Dubai in
September 2003.
31
Griffith-Jones, Melanie, Miguel Segoviano & Stephen Spratt (2004) CAD3 and Developing Countries:
the Potential Impact of Diversification Effects on International Lending Patterns and Pro-cyclicality,
through http://www.ids.ac.uk/ids/global/Finance/pdfs/SGJCAD3Submission.pdf
32
See for instance M. Vander Stichele, De toenemende rol van banken in het financiële systeem,
October 2000, p. 41.
33
See for example Harald Benink, Are Basel II’s pillars strong enough?, in The Banker, 1
st
of july 2004,
through
http://www.thebanker.com/news/fullstory.php/aid/1690/Are_Basel_II%92s_pillars_strong_enough_.html
34
Griffith-Jones, Stephany & Spratt, Stephen, “Will the proposed Basel Capital Accord have a net
negative effect on developing countries ?”, mimeo, Institute of Development Studies, University of
Sussex, Brighton (via: http://www.jubileeplus.org/analysis/articles/griffith_jones_Basel_capital.htm)
35
See for example Andrew Cornford, A review of comments…precieze verwijzing??
36
Basel Committee, Consultative document - The New Basel Capital Accord, April 2003.
37
A. Persaud, The Basel plan must get back to market basics, in FT, 3 September 2003.
38
For information see: http://www.iaisweb.org
39
IAIS, Credit risk transfer between insurance, banking and other financial sectors, Press release, 7 April
2003.
40
Most information from : http://www.iosco.org
41
Basel Committee on Banking Supervision, Recommendations for public disclosure of trading and
derivatives activities of banks and securities firms, Basel committee Publications, nr. 60, October 1999.
42
IOSCO, The Technnical Committee of IOSCO today issued a Statement of Principles to guide
regulators and other s in addressing the conflicts of interest securities analysts may face, press
release, IOSCO, 25 September 2003.
43
Financial Stability Forum, Statement by Roger W. Ferguson, JR., Chairman of the Financial Stability
Forum, International Monetary and Financial Meeting, 21 September 2003.
44
Andrew Parker, Watchdogs seek better assistance, FT. December 13
th
2004
45
See for instance: Basel Committee, IOSCO, IAIS, Joint Forum releases cross-sectoral reports, press
release, 7 November 2001; www.iaisweb.org.
Critical Issues in the Financial Industry
Chapter 5 – Governmental regulations at the international level 167
46
See for instance an extensive study done on bank regulation and supervision in 107 countries to
assess the relationship between specific regulatory and supervisory practices and banking sector
development and fragility: J. Barth, G. Caprio, Jr. and R. Levine, Bank regulation and supervision: what
works best?, January 2002.
47
See box: Scandals by major financial firms in chapter 1.
48
Group of Ten, Report on consolidation in the financial sector, January 2001, p. 3-6.
49
Wholesale activities such as payment and settlement systems.
50
Public disclosures by banks: results of the 2001 disclosure survey, in Basel committee publications, nr
97, May 2003.
51
See Financial Stability Forum
(http://www.fsforum.org/compendium/how_is_the_compendium_organised.html)
52
Information for this overview is taken from the overview made by the Financial Stability Forum
(www.fsforum.org) and the websites mentioned except if otherwise stated.
53
Australia, Canada, France, Germany, Hong Kong, Italy, Japan, Netherlands, Singapore, United
Kingdom, United States; the Financial Stability Forum members also often meet with authorities from
non-member countries in Central and Eastern Europe, Latin America and Asia.
54
http://www.bis.org/cgfs/index.htm
55
http://www.imf.org
56
A. Krosta, F. Schmid, IMG urges change in German bank rules, FT, 16 September 2003.
57
http://www.oecd.org
58
The OECD has 30 member countries, most developed economies with market economies.
59
See Bank profitability - Financial statements of banks: Edition 2002, at www.oecd.org > finance and
investment > documentation > documents-statistics, data and indicators > bank profitability - Financial
statement of banks: Edition 2002.
60
http://www1.oecd.org/fatf/
61
Tax havens seek WTO intervention, in FT, 2 October, 2000.
62
Bankentoezicht minder streng na aanslagen VS, in Het Financieele Dagblad, 10 December 2001.
63
Financial Stability Forum, Statement by Roger W. Ferguson, JR., Chairman of the Financial Stability
Forum, International Monetary and Financial Meeting, 21 September 2003.
64
BIS, The international banking market, in Quarterly review, December 2003, p. 16
65
See for instance: Under the regulatory yoke, in FTfm, 19 January 2004, p. 28; For an overview of
some lobby groups, see annex to this report
66
See: www.iif.com
67
M. Vander Stichele, De toenemende rol van banken in het financiële systeem, SOMO, October 2000,
p. 12,14-15.
68
J. fuller, No one attempted Parmalat jigsaw, in FTfm, 19 January 2004, p. 6.
69
The Economist, Accounting Standards. A question of measurement, October 23
rd
2004.
70
See for instance: A. Parker, IASB to ease draft rules for EU banks, in FT, 21 August 2003.
71
For a comprehensive set of recommendations, see below: Friends of the Earth - US, Sustainability and
accountability in the financial services sector, declaration released in January 2003.
(http://www.foe.org/camps/intl/financialregs.html)
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 168
Chapter 6
Trade in financial services:
liberalisation in the GATS Agreement
and insufficient assessment of the
risks
The General Agreement on Trade in Services (GATS) is the only agreement at the
international level which regulates and liberalises trade in financial services as well as
investment of financial services providers. The GATS agreement was negotiated in the
Uruguay Round (1986-1994) and since 1995 had to be applied by all the WTO members
(148 by mid 2005). GATS is part of the World Trade Organisation (WTO), including the
WTO's decision-making and dispute settlement structures. Liberalisation of financial
services is also dealt with in many regional and bilateral trade agreements but will not be
analysed in this chapter; many points of analysis might however be the same.
The general principles and rules of the GATS agreement also apply to financial services.
In addition, the GATS agreement has special instruments that only relate to financial
services, as explained below.
This chapter also includes an analysis of the risks that financial service liberalisation and
GATS rules entail for financial instability and wider society issues in developing countries.
These risks are not widely or publicly discussed in the current GATS negotiations and
brushed aside by Western financial services negotiators.
6.1 The GATS instruments to liberalise financial services
The GATS agreement has different ways to liberalise services, in casu financial services.
First, it is necessary to clarify what kind of trade in (financial) services is covered by
GATS, because it includes investment by foreign (financial) firms.
6.1.1 The rules of the GATS Agreement
6.1.1.1 The definitions of “trade in services”
According to the GATS agreement, trade in services can take different forms:
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 169
Mode 1: cross-border movement of the service or "cross border trade": e.g. a
financial firm established abroad is allowed to provide services to nationals such
as banks deposits via internet banking.
Mode 2: cross-border movement of the service consumer or "consumption
abroad": e.g. an Indonesian art trader is allowed to take a loan from a bank based
in the Netherlands.
Mode 3: cross-border movement of the corporate service provider through
investments or "commercial presence": e.g. a country allows foreign banks to buy
up domestic banks or to open up branches in its territory.
Mode 4: "cross-border movement of persons": e.g. a Brazilian manager of a
Dutch bank is allowed to work at the offices of the Dutch bank in Amsterdam or
New York.
6.1.1.2 Liberalisation of services under GATS
One part of the GATS agreement deals particularly with liberalisation of (financial)
services, i.e. opening up markets to allow services and services providers to enter the
country. A country can decide which (sub)sectors it liberalises, or "makes commitments"
in, by adding them to its GATS list ("schedule"). For instance, a country can fully or partly
liberalise its financial services under GATS. A country's GATS schedule specifies which
(financial) sub-services are liberalised for which "modes", and can include exemptions to
some GATS rules. A country can decide not to make a commitment in financial services by
not adding financial services to the schedule.
The decision to open up, or not, certain services sectors is an important part of the GATS
negotiations. A country receives "requests" from other WTO members, i.e. lists of services
for which other countries demand market opening. A country then replies with an "offer", a
list of services it is prepared to liberalise. Subsequently bilateral secret negotiations follow
in which countries bargain between each other's offers and requests. Although this
process is supposed to be a give-and-take exercise, this is in practice often not the case
because power games and arm-twisting happen during the negotiations. At the end of the
bilateral negotiations between the many WTO members, each country includes a
schedule of services for which it grants new market openings in the GATS agreement and
which is valid for all WTO members (Most Favoured Nation Principle).
6.1.1.3 The GATS rules and obligations that apply to financial services
The GATS agreement is based on the assumption that many barriers to trade in services
and limitations on the operation of foreign services' firms come from government
regulations, measures and administrative decisions. The GATS agreement has a set of
rules and obligations that governments have to implement to allow foreign service
providers to operate more freely. It includes the following disciplines, which also apply to
financial services:
1. General obligations that a country has to implement even if it has not liberalised any
(financial) services under GATS:
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 170
treating all foreign (financial) services equally (Most Favoured Nation /
MFN) (Art. II);
transparency: openness and notification of all measures and new laws on
(financial) services to other WTO members (Art. III);
facilitate the increasing participation of developing countries in world
trade in services through negotiating specific commitments and
establishment of contact points by developed countries (Art. IV).
2. Specific obligations applying to (financial) services that have been liberalised, i.e.
committed in the GATS schedule of each WTO member:
due treatment of foreign services suppliers when taking administrative
measures or giving authorization to supply a (financial) service (Art.
VI.1.,2.,3.);
ensure that standards, licensing and qualification requirements do not
constitute a barrier to trade (Art. VI.4.,5.): more disciplines need to be
negotiated;
no restrictions on international payments for current transactions related
to committed (financial) services (Art. XI), except in case of balance of
payment problems (Art. XII);
no measures that limit the operation or ownership of (financial) services
e.g. limitation on the number of branches (market access obligations in
Art. XVI);
equal treatment of foreign and national financial service providers
(national treatment according to Art. XVII);
a GATS commitment to liberalize can only be reversed by a country after
three years and in addition, the WTO trading partners can request
compensation that needs to be negotiated (Art. XXI).
3. Continuous liberalisation negotiations
Under Art. XIX, the WTO members agreed to periodically start new negotiations to further
liberalise the service sectors of each country, while respecting national policies. The first
such negotiations started in 2000 and have been included in the Doha Round of
negotiations (start November 2001). However, the negotiations started without duly
implementing Art. XIX.3. that calls for carrying out an assessment of the experience in
trade in services.
During the current GATS negotiations, leaked "requests" from the EU make clear that
market opening mostly means eliminating national laws and regulations that are seen as
barriers to trade or in fact just a barrier to make maximum profit by the foreign (financial)
services firms.
Regarding GATS rules, difficult negotiations are still underway on domestic regulation (Art.
VI.4.), emergency safeguard measures (Art. X), subsidies that can be allowed or not (Art.
XV), and procurement of services by and for governments (Art. XIII). Developed and
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 171
developing countries have opposing interests, which constantly delays the negotiations
and agreed deadlines.
6.1.2 The Annex on Financial Services
The Annex on Financial Services is fully part of the GATS agreement and provides some
specification on how authorities can take measures relating to financial services. In
addition, the Annex (Art. 5.) provides a non-exhaustive list of insurance, banking and other
financial services that are subject to GATS rules and commitments.
The Annex describes which "services supplied in the exercise of governmental authority"
are exempted from the GATS agreement (Art. 1), such as activities by central banks or by
the public retirement systems.
Prudential carve-out
Art. 2 of the Annex specifies that WTO members can take measures for prudential
reasons such as protecting investors and depositors, and ensuring the stability and
integrity of the financial system even if such measures do not conform with GATS rules.
However, prudential measures should not be abused to circumvent GATS rules nor
commitments made under GATS.
In case of a financial services trade dispute, the WTO panel is assumed to have the
necessary financial expertise.
The Annex (Art. 3) specifies how countries can make agreements to accept each other's
prudential measures.
6.1.3 The GATS agreement includes a model for swift
liberalisation
The financial services have received a special separate text belonging to the GATS
agreement to promote their quick and full liberalisation through several means: The
Understanding on Commitments in Financial Services. If a WTO member agrees to open
up its financial services according to the 'Understanding', then it has to make the
commitments as described below, with a right to schedule exemptions. All industrialized
countries have accepted the Understanding as the basis of their commitments and see it
as a minimum for others, but only very few developing and emerging market countries
have joined in. In total only 30 countries have opened up their financial services according
to this Understanding.
A model for extensive market access
The Understanding (Part B.) provides a set of market openings to be applied by WTO
members that implement the Understanding. Such market opening relates to:
cross-border trade (mode 1) for a few insurance services and for services in support of
banking and investment (e.g. advice),
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 172
the right of consumers to purchase abroad (mode 2) financial services mentioned for
mode 1 as well as all other banking or financial services,
the right of establishment and expansion by all foreign service financial providers (mode
3), including through acquisitions, and the right of governments to impose some
conditions,
the temporary presence of managers and specialists in financial services (mode 4).
Moreover, any new conditions to the above market opening may not be more restrictive
than those already existing (standstill in restrictions - Part A.).
Members can include this set of market opening in their schedule or still choose to make
up their own GATS schedule in which they open up some (financial) services to foreign
suppliers.
Erosion of exemptions from GATS rules
The Understanding (Part. B.1.- 2.) invites WTO members not to apply exemptions which
are allowed by the GATS agreement to financial services! This means that regulations
about procurement of financial services by public entities should be in conformity with the
principles of national treatment and most favoured nation while this is not necessary
according to Art. XIII. The Understanding also requires each WTO member to list in its
schedule monopoly rights provided to financial services and strive to eliminate them (while
they are allowed under GATS Art. VIII) as well as list and eliminate financial activities
conducted by a public entity for the account of the government (allowed in the Annex on
Financial Services Art. 1.(b).(iii)).
Eliminating all barriers to trade in financial services
The Understanding (Part B.10.) also requires members to remove any obstacle to foreign
financial services that remains even if all the provisions of the GATS agreement have
been respected. Following on, the Understanding provides guarantees that
foreign financial service suppliers:
are permitted to introduce any new financial service (Part B.7.),
are not hindered in the transfer of information (Part B.8.),
have access to payment and clearing systems operated by public entities (except
lender of last resort facilities) (Part C.).
Foreign financial companies see the lack of such guarantees as (non-tariff) barriers to
their trade.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 173
6.1.4 After the Uruguay Round: the Fifth Protocol to the
GATS
At the end of the negotiations of the GATS agreement in 1994, some WTO members and
especially the VS (read: its financial lobby) were not satisfied with the commitments made
by WTO members on financial services. It was decided to continue the negotiations on
financial services specifically, which lasted until the end of 1997. The Fifth Protocol to the
General Agreement on Trade in Services contains the lists of countries that agreed upon
more market openings for financial services than in 1994. Although the Protocol entered
into operation in 1999, several members have postponed their acceptance of the protocol,
amongst others Brazil.
6.2 Assessing the risks for developing countries
6.2.1 Liberalisation of financial services under GATS
6.2.1.1 GATS negotiations reinforce the interests of Western financial firms
The opening of markets for financial firms from the US and other Western countries has
been one of the key forces behind the GATS negotiations during the Uruguay Round
(1986-1994). Under pressure from its financial lobby, the US was unwilling to give most
favoured nation (MFN) status to countries that did not open for US financial services, one
of the reasons why exceptions to MFN were allowed. The US dissatisfaction with financial
services market openings during the Uruguay Round lead to complementary GATS
negotiations on financial services. The latter were concluded at the end of 1997 (see
above: Fifth Protocol) after the US had been pushing much harder for market opening
than the EU. The lobby of the world's major financial firms was strongly present behind the
scenes and was even involved at the highest level through the Financial Leaders Group.
1
Afterwards, the EU negotiator, who had phoned them from the negotiating room according
to a lobbyist, openly praised the EU financial lobbyists.
Especially the emerging market countries were under pressure to open up their markets
even though the Asian financial crisis had already erupted in 1997. The WTO and others
argued that liberalisation of financial services would not enhance the financial crisis but
rather strengthen the 'weak' financial sector in crisis-stricken countries. Some observers
claim that additional market opening was forced by the US in return of financial packages
to help countries survive the financial crisis.
Again during the GATS negotiations that started in 2000, the basic negotiation position of
the EU and other Western countries is to aggressively open up more markets for their
financial services. The leaked requests of the EU to developing countries
2
read like a wish
list of European financial firms by which all governmental measures that hamper their
expansion and profit making would be removed. For example, a recurring demand in the
EU requests is that developing countries give up their restrictions on full foreign ownership
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 174
of banks such as compulsory joint ventures. The EU argument is that full ownership
results in better allocation of resources than in financial firms that must involve local
elements. However, increased full foreign ownership of banks raises many issues, as
explained below. The ultimate examples of industry lobbying are where the leaked
requests state "EU industry raises this issue" (e.g. in request to Thailand).
The financial services in 'emerging markets' and higher-income developing countries are
again a major target of the EU requests, although the EU has also addressed financial
service requests to 20 least developed countries and 30 low-income countries.
3
The US
strategy is presumably the same or even more aggressive but details remained secret.
The financial market of Russia, which is negotiating to become a member of the WTO, is
an important target of the American insurance industry. The American Council of Life
Insurers
4
stated that it would oppose Russia's accession unless Russia guarantees
market access to foreign life insurance companies. Developing countries have little
financial services to export so that the market opening demands of the Western financial
firms dominate the current financial services negotiations.
The liberalisation negotiations on financial services in GATS fit neatly with the
consolidation strategy of the world top financial industry (see chapter 2) and will reinforce
it. The GATS negotiations do not only provide the financial industry with access to more
markets and improved chances of full ownership of banks worldwide through mergers and
acquisitions. The GATS agreement also guarantees that this liberalisation is difficult to
reverse (Art. XXI) and that national measures that hamper profit making and consolidation
are being restricted (e.g. Art. VI, XVI and XVII). The 'Understanding on Commitments in
Financial Services' (see above) clearly underpins the interest of financial conglomerates
that are engaged in cross-border and cross-sector consolidation. The EU requests many
developing countries to open up according to this 'Understanding'.
6.2.1.2 Few instruments to deal with increasing concentration
As explained in chapter 2, some sub-sectors of financial services have a high level of
concentration with a few companies dominating world wide, such as in investment
banking, derivative services and rating agencies. Financial firms from emerging markets
and developing countries have no capacity to compete in those concentrated sectors at
the national or international level. In five East Asian countries, American and European
banks have been able to dominate in capital market services
5
(incl. investment banking)
and large syndicated loans.
6
When opening up these financial sub-sectors, WTO members have to be aware that
foreign firms will easily dominate. However, it might be too costly for national authorities to
support the development of national service providers in these sectors.
Concentration of financial services leaves governments – which need private finance –
and customers with too little choice. It opens the way to abuse of economic and market
power such as tacit price-fixing and high prices that are detrimental to development.
Secret price-fixing occurs but seldom comes to light as happened in Germany by the
insurance companies
7
and in Kenya where a cartel of foreign banks fixed high interest
rates.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 175
The GATS agreement has only very weak instruments to tackle problems related to
concentration and consolidation (see also chapter 2). GATS Art. IX recognizes that
business practices may restrict competition and trade in services but does not contain real
competition policy measures. Only when restrictive business practices occur at the
national level by foreign service providers can the domestic authorities ask for
consultations. The home country should only give "sympathetic consideration" to such
requests and non-confidential information. Moreover, the negotiations on emergency
safeguard measures to protect the local (financial) services industry from being
overwhelmed by foreign services, are being opposed and constantly postponed by
Western countries.
Critical issues
How far will consolidation go?
Further liberalisation under GATS is likely to increase consolidation and
concentration. It is however not discussed up to what level consolidation will be
allowed at international level. Will supervisory authorities intervene in trade
policies when banks become too difficult to monitor and “too big to fail”? Financial
firms will argue that further consolidation is the most important strategy in current
international competition. In case the same few top financial firms will compete in
all countries and thus form a worldwide oligopoly, can WTO members reverse
their liberalisation under GATS without paying compensation?
6.2.1.3 The arguments behind liberalisation of financial services
In the literature
8
and in discussions, many arguments can be found in favour of, as well as
against presence of foreign banks.
The arguments put forward by those in favour of liberalisation are:
reduction in overhead expenses and profit-taking by domestic banks due to
increased competition by foreign banks;
increased efficiency and diversity of financial services;
spill-over effects of foreign bank entry, such as the introduction of new financial
services and of modern and more efficient banking techniques, and the
improvement of domestic bank management;
improvement in bank regulation and supervision due to the entry of new financial
service providers and new financial services;
less interference by governments in the financial sector, to cover up bad
practices;
training by foreign banks, resulting in more experienced personnel in the financial
sector of a country;
the presence of foreign banks stimulates domestic investment in the host
countries;
foreign banks may attract (other) foreign direct investments and enhance a
country’s access to international capital;
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 176
well capitalized foreign banks may be able and willing to keep lending to domestic
firms during adverse economic conditions, while domestic banks would probably
reduce the credit supply;
foreign bank entry leads to better lending terms (lower interest rates, lower fees,
longer maturities) for all but larger firms.
The arguments put forward for those opposing foreign entry are:
domestic banks are not able to cope with increased competition, and may stop
operating, which can cause disruptions and political concerns about increased
foreign control of the financial market;
trying to cope with increased competition from the foreign banks and
implementing new techniques may raise costs for local banks in the short term,
which they would then finance by raising their profit margins, in turn leading to
price increases for consumers;
foreign banks get higher interest margins;
foreign banks' entry into the market of loans to corporations does not decrease
the margins and profits in the personal loan market;
foreign banks will not provide additional credit during an economic downturn in a
host country;
foreign banks will leave the country when the profitability is too low, which can
undermine stability in financial services;
changes in economic conditions in the foreign bank’s home country may have a
negative effect on bank activity in the local market;
foreign banks only provide credit to large and often foreign-owned (multinational)
firms, and tend to lend less to small firms and poor consumers;
domestic supervisory and monetary authorities often fear that their influence on
banks’ behaviour may diminish as supervision of foreign banks' branches is done
by the authorities of the home country.
6.2.1.4 Experiences of financial services liberalisation in developing countries
The evidence of liberalisation of financial services in developing countries seems to be
mixed. The literature provides mainly evidence from banking and some few other financial
sub-sectors or from a particular perspective. Many data are missing to provide a full
picture. In order to guide negotiators, economic models do not exist to assess the full
impact of future financial services liberalisation. Moreover, no overall assessment of the
experience in trade in (financial) services was carried out as GATS Art. XIX.3. calls for.
From the literature and research done by SOMO, the experiences of developing countries
seem to be well reflected in the assessment of trade liberalisation in financial services
made by China
9
which included the following issues.
10
(a) Positive effects:
Improving efficiency, functioning and management
Foreign banks have been improving the functioning of the financial system in China: they
are promoting the competitiveness of domestic banks and bringing in new experience in
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 177
risk management, internal controlling, incentive mechanisms, business innovation and
accounting.
In Sub-Saharan Africa, experience of increased foreign participation in the domestic
banking sector to date has shown such benefits as improved quality, pricing and supply of
financial services and in risk management, accounting and transparency as well as
increased competition.
11
Especially in poorer developing countries where the banking
system is considered inefficient and unreliable, the entry of foreign banks is claimed to
make domestic banks more efficient and avoid the high economic cost of inefficiency that
prevent development, trade and investment.
12
Research findings differ whether domestic banking efficiency increases by a large number
of new foreign entrants or by (a few) new entrants with large market shares.
13
Increased access to foreign capital
In China, foreign financial firms have increased foreign capital inflows and the investment
environment has improved.
Introducing new financial services and innovations
Foreign financial services companies have provided more advanced services and financial
innovations to consumers in China. In insurance, a major US insurance group (American
International Group) introduced an insurance marketing system, stimulated the domestic
insurance market, strengthened the idea of customer-oriented service among Chinese
insurance companies, and promoted the development of the personal life insurance
market.
(b) Negative effects:
“Cherry picking”
China has experienced that domestic banks loose especially rich clients (“high end
consumers”) to foreign banks. Since such rich clients provide most of the profit for a bank
(according to Chinese statistics: 80% of the profits come from the richest 20% of the
clients), domestic banks are losing profitable clients and are left with the less profitable
ones. This can further undermine their capability to compete with foreign banks, which in
turn are not interested in serving poorer clients.
In Turkey, for instance, foreign banks have chosen aggressive strategies to only focus on
large lucrative clients (e.g. multinationals, governments) and projects (e.g. privatization).
14
In Sub-Saharan Africa and elsewhere (e.g. India), foreign firms use their financial power
and international status to focus on the most lucrative transactions and lure rich and
middle class customers. These findings confirm a case study of the Dutch bank ABN
Amro in Brazil, which showed that it was not more efficient than domestic banks which
had survived many financial crises but many people trusted its status as a foreign bank
which attracted richer people who were willing to pay more.
15
An important question is whether this cherry picking by foreign financial firms mobilizes
more domestic savings or rather increases capital flight.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 178
Undermining poverty eradication
This cherry picking and market segmentation is undermining poverty eradication (see
chapter 1) as foreign financial firms are hardly interested to expand their services to the
poor. As was researched in Kenya
16
, the situation is similar for foreign health insurance
companies. These companies tailor their services to the wealthy city-dwellers who are
already able to pay their hospital bills. They charge high premiums, unaffordable to poor
patients. They refuse to accept patients who suffer from illnesses such as HIV/AIDS. This
is in sharp contrast to the government’s public health insurance system, which is obligated
to accept all patients.
The recent situation in some Latin American economies also highlights the risk that
foreign banks will not offer their services to smaller clients like households and SME’s.
Especially in Mexico, where foreign banks control 85% of the total banking sector but
provide too little lending to local companies to stimulate economic growth. Politicians and
supervisors have expressed their doubts on the past decision to open their banking sector
up to foreign competition. Households and SME’s hardly have access to credit at
reasonable rates. The government is considering legislation that will make it mandatory for
banks to change their lending practices.
17
Critical issues
GATS 'flexibilities' not used
During the previous GATS negotiations, Kenya agreed to liberalise its financial
services without fully realizing that it was also subjecting the health insurance
sector to the GATS rules. Article XVI prohibits governments from taking six
specific kinds of measures to place limitations on companies, such as economic
needs tests and restrictions on the number of service suppliers. During the
negotiations, the Kenyan government could have reserved the right to impose a
universal service requirement for foreign insurers only, but did not do so. The
government can now require foreign companies to insure poor and vulnerable
(HIV-positive or terminal) patients only if it also sets the same requirement for
Kenya-based insurers, according to the GATS principle of non-discrimination and
national treatment (Article XVII). Whether countries will impose universal service
obligation is another matter, as it is considered to have an unfavourable impact on
the financial firms’ profitability and stability, and thus discourage investments.
18
Widening the gaps
In China, the imbalance of economic development between the eastern and western
regions is widening further as more foreign investments and their banking services flow to
the more developed eastern part of the country. Taiwan equally experienced that foreign
financial firms stayed in the capital areas and did not go to the non-profitable rural areas.
19
When foreign banks are easily dominating the most lucrative services as is the case in
South East Asia for investment banking and syndicated loans, domestic banks might
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 179
specialize in catering to the credit needs of small and medium-sized firms and
households. In such situation, liberalizing financial services may not result in the
proclaimed improvement of competitiveness and efficiency of the domestic financial
service industry through transfer of new sophisticated financial technologies.
Critical issues
Undermining lending to non wealthy borrowers
In case local banks do not survive the competition from large foreign banks, their
expertise and capacity to borrow to small producers and poorer households will
be lost. This can enhance the divide between small and rich producers, make
poverty eradication more difficult, and have an impact on the whole economy.
Widening the gender gap
If cherry-picking is common practice by foreign financial firms, it has also gender
implications in developing countries. Women constitute the majority of the poor
and are often very small producers or entrepreneurs. Although the female rate of
repayment of loans is high, their lack of collateral means that they often have to
rely on micro-credit systems for financing. If financial services liberalisation does
not provide them with better access to finance while larger entrepreneurs are
better financed, their fight against poverty might be undermined and the gender
gap increased.
The experience of 80 countries between 1988 and 1995 shows that foreign banks in
developing countries tend to have greater profits, higher net interest margins and higher
tax payments than domestic banks.
20
Critical issues
Transferring wealth from poor to rich countries
Foreign financial firms that make profits from richer clients in developing countries
and transfer that profit abroad, are thus transferring some of the wealth from
developing countries to the rich home countries. Moreover, Art. XI of GATS does
not allow restrictions on profit repatriation.
Brain drain from local to foreign banks
In China, domestic banks are losing many capable senior executives and key personnel.
This leads to a lack of experienced executives in domestic banks and further undermines
the swift development and improvement of these banks. Such experience contradicts the
argument that foreign presence of banks lead to transfer of know how.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 180
(c) Challenging problems
Swift expansion of foreign financial services
During the second half of the 1990s
21
, there has been a dramatic and very rapid increase
in foreign ownership of banks and foreign banking activities in many developing countries
and in China. Figures indicate
22
that the presence of banks from developed countries
increased:
by more than 59% in East Asian countries
23
between 1996 and 2001,
by 364% in Latin America
24
during the period 1996-2000, and
by 85% in Central and Eastern Europe
25
during 1996-2000.
In Tanzania, liberalisation for foreign banks increased their presence from 5% before 1980
(when policies where restrictive) to 76% in 2002.
The entrance of foreign insurance companies has also shown a dramatic expansion of
these companies in a short period of time in China.
It is difficult to establish whether the GATS agreement on financial services (1997) had an
influence on this large increase of presence of Western banks. There was a general trend
towards opening up financial sectors during that period -which was reflected in some
GATS schedules
26
- alongside the strategy of many internationally operating financial firms
towards global consolidation.
The EU (and US?) requests during the current GATS negotiations to eliminate restrictions
on full foreign ownership in small or poor developing countries can easily lead to
domination by foreign banks. What are the consequences for monetary and development
policy when foreign financial service providers control more than 75% of the banks, as is
the case of Tanzania, and more than 80% of private financial assets, as is the case of
Mexico?
Moreover, dominance by foreign banks makes these countries vulnerable to strategies of
financial conglomerates that leave the country when profits decline. This makes it more
difficult for the authorities to monitor the financial system.
Critical issues
Difficulties to keep up with the rapid changes
Rapid increase of foreign financial firms make it difficult for domestic financial
firms to meet the fierce competition, while the supervisory and regulatory
authorities have trouble keeping abreast of the developments and their risks.
Allocating more savings of developing countries to the rich countries?
Foreign financial conglomerates have more expertise on how to allocate domestic
savings and capital in Western investments than the domestic financial firms in
developing countries. It might be too costly for foreign financial service providers
to fully explore new investment opportunities in the host country. When
developing countries have liberalised their financial services and capital account,
more of their savings get allocated to the North (e.g. Northern company shares)
and not in domestic investments. In this way, domestic economic development
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 181
opportunities are lost and the global imbalance of capital allocation reinforced. As
more and more developing countries' banks are being privatised, governments
have fewer opportunities to prioritise the financing of domestic (service)
industries.
Little capacity to export financial services
GATS has also provided for China’s financial firms the opportunity to establish abroad, but
Chinese financial services lack the competitive edge (and still need a lot of restructuring)
to expand abroad to the extent that foreign financial services are capable of entering the
Chinese market. This adds to a deficit in services trade, and to balance-of-payments
problems.
In Africa, the insurance sector has so far remained underdeveloped and without the
necessary backing from governments. Lack of capacity and expertise has prevented the
sector from starting viable commercial relations among African countries and making them
fully prepared for international competition at home and on international markets.
27
Need for new regulatory and supervisory bodies
After opening up its financial services sector under GATS, China needed to introduce new
regulatory bodies for supervising the insurance and securities' sectors, alongside those
regulating and supervising the banking sector. This can strengthen the financial sector
and its stability. However, given the required swiftness, cost and expertise, many
developed and developing countries have not yet finalised their regulatory and supervisory
reforms (see chapter 5). Note that in the West, regulators and supervisors have come to
the conclusion that banking and insurance supervisory bodies are not adequate and need
to be integrated because financial firms increasingly integrate banking, insurance and
securities (see chapter 5: these reforms have not yet fully taken place in all developed
countries).
How much progress in efficiency?
In Sub-Saharan Africa, the presence of foreign banks increases loans by both domestic
and foreign banks, but the variability of the loan supply decreases. Foreign banks in Sub-
Saharan Africa do not necessarily have fewer bad performing loans nor are they better
capitalized than local banks – although better capitalization is often claimed as an
advantage they enjoy, making them more resistant to financial crises. Foreign banks can
out-compete locally owned banks in smaller economies because they can recover their
high set-up costs from profitable operations elsewhere.
28
The high presence of foreign banks Latin America
29
shows that the stimulus for domestic
banks to increase efficiency through lower overhead expenses and less profit taking only
works out in countries at the lower levels of economic development (e.g. Peru, Colombia,
Ecuador and Bolivia), but not for the more developed countries such as Brazil. Note that
“more efficiency” by local banks means “less profit”. Less profitability and greater
competition can avoid abuses but also lead to more risky lending practices by smaller
local banks.
30
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 182
Risks of financial instability
The risks of financial instability in developing countries resulting from financial services
liberalisation and GATS rules are being analyzed below as follows:
1. too little awareness that new financial services require new prudential measures
2. foreign financial services increase cross-border capital flows and financial instability
3. GATS articles advance cross-border capital flows and capital account liberalisation
4. GATS articles challenge measures to deal with destabilising capital flows
5. GATS articles undermine prudential measures and regulations domestic authorities
take
6. GATS articles affect the management of the financial industry and instability risks
6.2.2 The risks of financial instability in developing countries
While the GATS negotiations in financial services are about liberalisation of financial
services, they affect the national (de)regulation of financial markets and financial services,
as well as measures that manage large capital transactions ("capital account"
31
). The
latter two sets of measures are nonetheless the domain of finance authorities and affect
the financial stability and economic situation of a country, especially in developing
countries. The experience with the recent financial crises in Asia and Argentina has
indicated that capital account liberalisation has increased the risk of a financial crisis in
developing countries that failed to develop a strong regulatory and supervisory framework
prior to liberalisation. Foreign banks contribute to a financial crisis by using capital account
liberalisation for imprudent short-term lending policies and “herding behaviour”, and by
hoping –mostly successfully- that governments will support repayment of commercial
debt.
Developing countries have already expressed their concerns that market opening and
GATS rules might result in capital movements that create financial instability and affect
governments' decisions to institute prudential measures to avoid a financial crisis. The
devastating effects of a financial crisis should prioritize negotiators' attention to assess the
risks and address the concerns. However, these concerns are not much publicly
discussed and hardly acknowledged by developed countries. As the World Bank puts it:
Access to financial services is what matters for development, not who provides it.
32
6.2.2.1 Too little recognition of the need for new prudential measures
During the current GATS negotiations, many developing countries are not well informed
what policy responses and prudential measures to take that avoid the risks of greater
liberalisation of financial services. The WTO Committee on Trade in Financial Services
discusses some of these issues, including experiences of the range of new financial
measures and bodies introduced by some developing countries (e.g. Turkey, Malaysia,
China). However, many developing countries have no capacity to participate in the
Committee or to engage all relevant financial authorities back home.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 183
There is no widely accepted conceptual framework to make econometric estimates of
financial services liberalisation, and statistical data are inadequate to predict future
impacts.
33
Sudden intensification of competition by foreign new comers may encourage previously
protected domestic financial institutions to take short-sighted risky responses
34
, such as
reckless lending. Also foreign financial firms might engage in risky strategies to gain new
shares of the market. For instance, Argentina allowed large foreign ownership of banks
that failed to lend to small and medium-sized enterprises. The lack of safeguards to lend
to domestic firms prevented the Argentina economy to pick up after its first growth wave
ended in the 1990s.
35
In order to compete and attract more clients, financial conglomerates constantly introduce
new and more complex, hybrid financial products. If countries liberalise under GATS
according to he Understanding on Commitments in Financial Services (see above), the
host countries have to give permission to "any new financial service" that foreign financial
service providers introduce.
36
New services might include banking through internet and e-mail, 'e-banking', which poses
problems of supervision on money laundering and fraudulent activities, consumer
protection and avoidance of systemic failure.
37
Other new services might be derivative products and mutual fund management,
instruments that involve a significant speculative component.
Regulators and supervisors in developing countries will be challenged to take the
necessary measures and avoid the problems that occurred in Western countries, which
are supposed to have the best regulatory and supervisory regimes. As explained above,
Western countries had to revise regulations after problems of too much speculative
investment by pension funds and insurance companies. They also had to impose fines for
scandals of misusing knowledge, the creation of a stock market bubble and charging too
high fees.
China's experience
38
with foreign financial firms shows that transaction techniques have
become more complicated. As a result, China’s financial institutions are experiencing
tremendous changes, which increases the risk of instability. China has gradually reformed
its regulatory framework to adapt to international practice, but admits the administrative
capacity of the regulatory authority still falls far behind that of many developed countries
and that continuous reform and improvement is needed. This adds to the difficulties and
the high costs of administering the financial system.
In the future, Basel II rules might transform financial services markets in developing
countries (see above chapter 5). For instance, Basel II rules might make it more difficult
for domestic banks to compete against international banks that enter their market under
GATS commitments. Authorities will have to adapt to the situation and take necessary
measures.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 184
6.2.2.2 Foreign financial services increase cross-border capital flows and instability
One way by which foreign banks tend to import financial instability is by lending in
foreign currencies. In China for instance, foreign banks have become important
channels for bringing in foreign capital, by loans in foreign exchange amongst others. This
has had a major effect on China’s monetary policy, and has strained the macro-regulatory
mechanisms of its financial system.
39
The payment and repayment of loans in foreign exchange increase the rate of inflow and
outflow of international capital. When this results in an imbalanced exchange between
local and foreign currencies, it puts the exchange rate and foreign exchange reserves
under pressure, particularly if those loans are short-term. Too much demand for foreign
exchange increases the balance of payments deficit and with it the risk of exchange rate
and financial instability.
Other products that foreign financial firms introduce with financial market opening are for
instance "capital market products" such as investment instruments (e.g. mutual funds,
advise for management of a shares' portfolio). These instruments often offer domestic
residents to diversify their investments in shares and bonds issued by companies abroad
in addition to domestic ones.
40
Such services result in more cross-border capital
movements and can move in and out swiftly, especially when no capital movement
restrictions are in place.
New risk mitigation services and derivatives can also involve allocating money abroad.
While such services diversify risks, they are also speculative and it is difficult to estimate
by how much capital movements will increase and change direction.
When cross border capital flows reach significant volumes and a high velocity, or lead to a
balance of payments deficit, they can increase financial instability in the host country.
Speculative financial products can also import financial crises from abroad.
In addition, cross-border e-banking and buying foreign products -or even securities-
through internet ("mode 1" under GATS), typically involve cross-border capital movements
and foreign currencies. The lack of transparency in e-banking makes countries uninformed
how it will facilitate large destabilising cross-border capital movements, especially in small
countries.
41
What is difficult to predict
42
is how branches or subsidiaries of foreign financial firms and
their headquarters will behave in times of financial crises in developing countries.
Would they panic and move out all at once at the first sign of crisis as they did in 1997? Or
will they be able to resist the crisis with capital flowing in from the headquarters? In the
current Argentinean crisis, foreign banks refuse to recapitalize their branches and
subsidiaries.
43
Will they help transfer national savings abroad as in Argentina? Or will they
provide capital from abroad to finance current account imbalances? Most East Asian
countries have not been able to borrow in their own currencies, which means that they are
continuously exposed to problems that triggered the crisis in 1997. Smaller economies
such as in Sub-Saharan Africa are more vulnerable to capital movements which result in
financial volatility and destabilization of domestic bank credit.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 185
6.2.2.3 GATS articles promote cross-border capital flows and capital account
liberalisation
Some articles of the GATS agreement play a role in increasing the risks of destabilising
financial flows related to foreign financial service providers.
GATS Art. XI.1.
44
does not allow countries to restrict international transfers and payments
for current financial transactions that are related to services in sectors that were liberalised
under the Agreement. That means, first of all, that a country cannot prevent profit
repatriation by foreign service providers in sectors in which a country has made GATS
commitments. For instance, the EU requests from Chile in the current financial services
negotiations that Chile eliminates the "restriction" that prior authorization by the Central
Bank is required before transferring dividends from Chile abroad because this is in breach
of Article XI. Thus, if a country has liberalised the financial sectors, foreign banks and
insurance companies can transfer their profits abroad without reinvesting them in the
country. In countries that have small economies and/or large foreign investors in all
sectors, profit transfers affect negatively the balance of payments and exchange rate.
Moreover, Art. XI.1. has a special effect in relation to financial services provided by foreign
banks, insurers, investment bankers and asset managers which have established
themselves in countries that made GATS commitments in these services (Mode 3). These
financial service providers might view cross-border financial flows as "related to" or
essential to their services in cases such as:
lending in foreign currency;
buying securities abroad to balance the risks in pension fund management or to
increase the rate of return of asset management services (e.g. mutual funds) for
local clients or insurance companies;
providing investment bank services related to foreign stock exchanges
(underwriting shares of domestic firms listed abroad) or related to foreign
companies (acquisitions abroad);
offering international derivatives; and
using international credit risk mitigation mechanisms.
Such cross-border capital flows can go beyond current account transfers and undermine
management of the capital account aimed at avoiding financial instability and crises (see
box). If certain capital account restrictions frustrate the transactions of committed services
sectors, they could be challenged under GATS XI (see also below). In countries that have
already liberalised their capital account, GATS commitments in certain financial sub-sector
will increase instable capital flows. They might also discourage reversing capital account
liberalisation where considered necessary to avoid financial crises. Developing countries
that keep a high level of capital control are not likely to attract foreign financial firms as the
latter avoid unpredictable local currency convertibility and capital withdrawals.
45
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 186
Market opening in financial services and its impact on international
capital movements and financial stability
Article XI of the GATS is intended to guarantee the primacy of IMF rules in the area of
international capital movements. Obligations as to the liberalisation of cross-border
transactions in the WTO are linked to the commitments to market access included in a
country’s schedule and are designed to prevent their frustration in practice through restrictions
on the capital transactions necessary for their fulfilment. However, the decoupling in the GATS
of market opening for financial services from liberalisation of capital-account transactions
generally none the less leaves substantial scope for connections in practice. This is most easily
seen for the hypothetical example of a country which enters into commitments to no limitations
regarding Modes 1, 2 and 3 for all the activities mentioned in the Annex on Financial Services.
To ensure effective implementation of such commitments the country would be obliged to
undertake comprehensive liberalisation of capital-account transactions. Moreover a country -
not the one just described in the hypothetical example - whose commitments were made
through the Understanding on Commitments in Financial Services would also be making an
open-ended commitment to the liberalisation of such transactions required by its obligation to
“permit financial service suppliers of any other Member established in its territory to offer in its
territory any new financial service”. Although commitments as to market opening for financial
services often carry associated obligations as to the liberalisation of capital transaction, the
country making them will have to depend on guesswork for the estimation of the size of the
capital movements which are likely to ensue.
46
The difficulty of reaching estimates here is
increased by the pace of change in the financial sector, which is adding to the range of possible
transactions under the different modes of delivery of the GATS.
Source: A. Cornford, The multilateral negotiations on financial services: current
issues and future directions, 2003.
GATS Article XVI (“Market Access”) includes footnote 8 that commits a country to allow
a number of cross-border flows when it has opened up its market for particular (financial)
services: the country must allow inflows and outflows of capital that are considered
"essential" for (financial) services in mode 1 (e.g. e-banking) and allow inflows "related" to
mode 3 (i.e. foreign services provided by firms established in the country). Thus, countries
can only regulate the outflow of capital except for mode 1, if they have not already
deregulated capital flows by liberalizing the capital account as many developing countries
have done.
So far, the interpretation and impacts of Art. XI.1. and footnote 8 of Art. XVI in relation to
financial services are a little discussed area about which experts do not always have a
clear answer. This is reflected in discussions that have taken place
47
in the WTO about
opening up financial services that do not have a presence in the country but rather provide
their services from abroad (mode 1). Financial “products” such as lending of all types and
asset management provided by financial firms abroad can have a destabilizing effect
because they involve cross-border financial flows in foreign currency. In the view of Brazil,
the above mentioned footnote 8 of the GATS agreement could be tantamount to capital
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 187
account liberalisation and deregulation of major transfers of money, even if a country has
not fully liberalised its capital account system. Such cross-border capital transfers could
affect the balance of payments and the whole financial stability of a country. The
European Union, the US and other western countries downplay the importance of the
impact of opening up Mode 1 in financial services, but too little research has been done to
date on this issue.
6.2.2.4 GATS articles undermine measures to deal with destabilizing capital flows
Financial authorities need to have the capacity to carefully monitor changes in cross
border capital flows that result from financial services liberalisation. They may want to take
measures to prevent too much financial instability, especially in small countries where
swift flows can have a major impact. But GATS rules do not only influence what cross-
border capital flows are permitted, they also influence how restrictions on those flows are
managed.
Formally, GATS does not prevent any country from taking prudential measures to protect
depositors, investors or to ensure the integrity and stability of the financial system.
Art. XI.2. states that "nothing in the GATS agreement shall affect the rights and
obligations of the members of the international Monetary Fund under the Articles of
Agreement of the Fund". This legitimates controls over capital transactions since the IMF's
articles continue to permit policy autonomy regarding such controls.
48
These rights and
obligations, however, are subject to the condition that "a member shall not impose
restrictions on any capital transactions inconsistently with its specific commitments
regarding such transactions". In other words, IMF rights cannot undermine GATS
commitments.
WTO members are allowed to not apply Art. XI.1-2. In case of serious balance of
payment problems, Art. XII allows countries to restrict their market opening in (financial)
services sectors (financial or other services sectors) for which they made liberalisation
commitments, and to restrict cross-border money transactions related to committed
sectors. However, a country that invokes these restrictions is bound to fulfil a number of
conditions, including:
use criteria of non-discrimination and least-harmful effects on foreign service
providers;
be consistent with the Articles of the IMF;
limit the period the measures are in place;
undertake consultations with WTO members.
Ultimately, the assessment of the IMF of the financial situation of the country determines
whether the restriction measures are to be allowed (Art. XII.5.(e)).
6.2.2.5 GATS articles undermine prudential measures and regulations
Art. 2 of the GATS Annex on Financial Services (see above) permits domestic
regulations and prudential measures that protect a country against financial instability and
foreign exchange exposure. This article does not define prudential measures but
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 188
stipulates that such measures are authorised to contravene other GATS provisions
("prudential carve-out"). However, the article states that prudential measures should not
be used to avoid market openings or obligations under the GATS agreement. These
conditions attached to the prudential carve-out measures may prevent countries from
taking measures, which, while contravening GATS commitments, are nevertheless the
most effective for dealing with financial instability.
The vagueness of what a prudential regulation may entail allows a WTO member to
challenge a measure of another WTO member as being not a prudential measure, but
rather a way to avoid GATS commitments or obligations. For instance, Western countries
robustly challenge prudential measures by China during current negotiations and WTO
reviews with the argument that they undermine financial services commitments.
49
In case
of disputes brought before the WTO, a panel must in such case decide what prudential
measure is permitted or trade restrictive to the foreign financial industry. Although the
GATS Annex on Financial Services (Art. 4.) specifies that a panel must have the financial
expertise necessary for the dispute, still, central banks and other regulators lose their full
freedom to impose the prudential regulations they see as essential.
6.2.2.6 GATS articles affect the management of the financial industry and
instability risks
GATS rules are oriented to protect foreign, in practice Northern, financial firms against
governmental measures that limit their expansion and profit making. As a result, some
GATS articles affect measures that especially developing countries have taken to avoid
abuses and risks taken by national or foreign financial firms, or to strengthen the domestic
financial industry before opening up to foreign competition.
Art. XVI on market access specifies six categories of measures which governments are
not allowed to carry out for those (financial) services on which they have made GATS
commitments. Governments sometimes use the prohibited measures in the financial
sector (which is central to its economy) for economic, sovereignty or prudential reasons.
Art. XVI prohibits:
limitations on the number of service suppliers (Art. XVI.a.) or service operations
(Art. XVI. c.)
limitations on the value of service transactions or assets (Art. XVI.b.),
measures that require specific types of legal entity or joint ventures (Art. XVI.e.),
and
limitations on foreign ownership capital (Art. XVI.f.).
Governments can only carry out such limitations for committed financial sectors if they
specify them as exemptions in the GATS "schedules" of their country.
Art. XVII on national treatment requires that foreign financial firms be treated not less
favourably than national firms. One of the implications of this GATS principle is that official
support for national financial firms in order to avoid financial instability, or to restructure
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 189
after a financial crisis, also needs to be given to foreign financial firms. There could be a
‘chilling effect’ if national support is not given because of potential conflicts with Art. XVII.
Licensing, qualification requirements and technical standards are part of ensuring the
integrity of the financial sector in some countries. They are being disciplined by Art. VI.4-5
on domestic regulation to ensure that they are not more burdensome than necessary
nor trade restrictive. As the latter principles still need to be developed, current
requirements and standards in financial services can be attacked as trade restrictive. This
is already the case with the EC’s requests for market opening for financial services to
different developing countries (see below). Eight small island countries
50
in the WTO have
heavily complained that footnote 3 of Art. VI.5. refers to international standard setting
bodies while small and developing countries have no say in many of these bodies which
impose costly regulation.
Interestingly, during the previous GATS negotiations, some countries have tried to
safeguard their freedom to take the regulations they see as necessary. They made explicit
references in their GATS ‘schedules’ to their prudential policy in order to be protected
against any GATS provision or commitment.
6.2.3 Who will decide on what prudential regulation and
capital account policies?
The contradictions between promoting trade and the interests of the financial service
industry on the one hand, and strengthening the national and international systems,
highlights many important issues that require an urgent answer.
6.2.3.1 The EU’s attack on financial regulations of developing countries
The current GATS negotiations to further open markets for financial services are mostly
done bilaterally between WTO members and based on ‘request lists’ and ‘offers’ (see
above). These negotiations are in principle secret but the requests of the EU were
leaked.
51
These texts demonstrate that the EU aims at eliminating many governmental
regulations which it considers trade restrictive for its financial industry. Developing
countries consider these regulations to be prudential or necessary for the country's
economy or financial industry.
Discouraging the strengthening of the domestic financial sector
Malaysia
52
has explained to the WTO that it has a 10-year programme to strengthen its
financial services sector after the financial crisis. The programme includes gradual
liberalisation without undermining financial stability, and measures that limit access by
foreign financial firms to the Ringgit. In its requests, the EU asks Malaysia
53
to remove the
latter measures such as "the prevention applied to foreign banks from having access to
local currency capital market".
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 190
Undermining domestic capital reserves
The EU requests to several countries to take away measures that compel banks to keep
reserves in the host country and not by the international parent bank at international level
(e.g. "allow branches to use parent's capital to meet prudential requirements", and "take
fully into account the guarantee extended by the branch's head office or by another
foreign bank for additional lending"). Such requests underestimate the need to allocate
reserves in the host country. Especially in times of world wide financial crisis, the parent
bank might not fulfil its guarantee for additional lending (as was the case in Argentina in
1994-1995
54
), might not have enough reserves for all its branches and subsidiaries world
wide, or might have its requested liquidity in foreign currency (adding to the complexity of
the crisis). It is easier and cheaper for financial conglomerates to keep capital reserves
central rather than divided in the countries of the different branches.
Encouraging tax evasion and off shore centres?
The EU made a request to Thailand to take away its limitation that foreign banks with an
offshore license cannot get access to the Thai market through full branch license. Most
foreign financial conglomerates are operating in 'offshore centres' such as the Cayman
Islands or Switzerland, which allow evasion of taxes and low cost transactions. As the
amount of money passing through offshore centres is huge, transactions with these
centres can be unreliable and volatile, and cause or transmit financial instability. How
does this EU request match the EU's own policy to confront offshore centres?
Interestingly, the US, Canada and Japan warned their financial firms to be wary of doing
business with he Caribbean offshore centres. The concerned Caribbean countries have
threatened to use the WTO dispute mechanism because when they considered these
warnings as restrictions on trade in financial services with those centres.
55
Limiting the scope to regulate in favour of poverty alleviation
In its request, the EU raises questions about the requirement applied to all banks in
Malaysia to provide quotas for low-cost housing and considers that it is a limitation that
should be scheduled. This means that measures to provide poorer families with the
financial resources needed for housing are not considered falling under the GATS "right to
regulate”, but rather as a trade barrier (read profit making restriction) that must be
exempted from the GATS agreement (Art. XVI), and ultimately eliminated.
Critical issues
Regulations that oblige banks to finance or invest in poor communities are not
popular with financial conglomerates. The EU request indicates that the secret
bilateral GATS negotiations might be a way to put pressure on such regulations
and ultimately to eliminate them. GATS rules might also undermine schemes that
reserve rural banking services to domestic banks, such as in the Philippines.
56
The right to regulate in the GATS preamble seems to be open to interpretation,
even for poverty related measures. This might be in contradiction with policies to
achieve the UN Millennium Goals.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 191
Exporting the problems of European pension fund managers?
The EU requests many countries to liberalise their pension fund management services.
The European pension fund managers have however proven to be not very proficient by
over-investing in the stock market and reduce their financial reserves for pensioners to a
level that regulators had to intervene. At a time when many private pension funds are still
in financial problems and privatization of pension funds is contested in Europe (Italy,
France) it would be politically inadvisable for the EU to promote private pension fund
management in developing countries.
Critical issues
Experience in Latin American countries shows that the benefits of pension reform
and privatization have been overestimated, and that the administrative costs are
high.
57
From a poverty perspective, the question is whether European pension
fund managers will be cheaper, make additional pension insurance available to
more poor workers or focus on the richest clients (cherry picking)?
The danger of secrecy and power plays in the GATS negotiations
So far is unclear how the different interpretations of necessary and prudential financial
regulations will play out during the negotiations. The EU has claimed that regulatory and
supervisory issues will be discussed during the bilateral negotiations but argues that its
requests are targeting trade restrictions. How will the EU handle the IMF’s assessment
that the regulatory system in Thailand is not yet efficient enough and that further
liberalisation entails systemic risks for that country?
During the secret bilateral negotiations, when the pressure to liberalise is the highest, it
will be a matter of the having most (economic) power to push for, or resist, the removal of
particular prudential measures. Prudential measures might be overlooked when trade
deals are made at the end of the Doha Round negotiations in order to achieve market
access in GATS that balances off other concessions (e.g. in agriculture by the EU and the
US). Harsh pressure to open up financial services takes also place during negotiations for
new membership of the WTO, as was the case with China.
6.2.3.2 Should the WTO handle disputes on prudential regulation?
Beyond those bilateral GATS negotiations on commitments, the question is what role the
WTO will or should play in prudential regulation. The negotiators have already discussed
the ‘prudential carve-out’ (see above) of the GATS Annex on Financial Services. Some
industrialised countries have proposed clearer definitions or closer links with international
standard setting bodies
58
or with supervisory activities of the IMF
59
. This could entail that
these standards or activities would be considered un-challengeable under GATS and
others not. In contrast, developing countries are more interested in keeping a broad
prudential carve-out that does not constrain their policy making.
One scholar (A. Kern
60
) puts the issue as follows: “[There is a] need to define prudential
regulatory standards in a manner that promotes a synthesis between trade and regulatory
values. The issue becomes whether the WTO should play a role in this process, and if not
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 192
which international bodies or organisations should be deferred to in setting international
standards of prudential regulation. The absence of a definition in this area means that
finding such a synthesis will be left to the adjudication proceedings of the GATS, and
potentially within the legislative jurisdiction of the WTO. The evaluation will also cover the
issue of the adequacy of the current international prudential mechanisms as benchmarks
for assessing a member’s prudential regulatory measures. This does not prepare for a
promising integration of the financial systems. It only stands to disturb the constitutional
balance of the international economic system by rendering GATS the de facto ultimate
arbiter of international financial regulation.” …“[T]he ambiguities surrounding the
interpretation of the concept of prudential regulation and its scope of coverage in the
‘prudential carve-out’ of the Financial Services Annex will likely result in many trade
disputes regarding the validity of prudential measures taken by members to ensure the
protection of investors, policyholders, shareholders, and to promote integrity and stability
of the financial system." …"[T]he WTO’s dispute settlement mechanism is an inefficient
mechanism to determine the right balance between free and open trade and prudential
safeguards.”
One of the issues that have not been clarified is whether measures to restructure
domestic banks after the Asian financial crisis, including injecting state money, are
distorting competition and discriminating against foreign financial service suppliers.
Already, the South Korean bank reform has been challenged in the WTO as a breach of
the WTO Agreement on Subsidies and Countervailing Measures, not under GATS! It
raises questions about the coherence between the WTO and the work of the IMF.
61
Critical issue
Danger of 'chilling effect' on Tobin Tax and other anti-speculative measures
The lack of clarity of what is allowed under the prudential carve-out of the GATS
raises the danger of a chilling effect on new measures that prevent a financial
crisis and its devastating effects on (poor) societies. For instance, in case a WTO
member made financial services commitments and introduced a currency tax
(e.g. “Tobin tax”) to stop volatile cross-border capital flows, the tax could be
accused by another WTO member of not being a prudential measure (as
opponents of the Tobin tax argue) or restricting international transactions related
to committed financial sectors (i.e. breaching of GATS Art. XI). Other WTO
members might refrain from introducing such tax fearing challenges under GATS.
6.2.4 Little link between the GATS negotiations and national
financial authorities
Notwithstanding the above described risks of financial instability and ambiguities about
prudential measures, the GATS negotiations make hardly any connection between the
functioning of the financial regulatory and supervisory system of a country on the one
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 193
hand, and the "requests" and "offers" on financial services on the other. No international
body is stopping requests for market opening in financial sectors, which are too risky in a
particular country.
The GATS negotiations on financial services liberalisation have often not involved officials
from the ministries and supervisory agencies working on reforms at the national level or at
international level (“the international financial architecture”). Especially in the EU and other
Western countries, the negotiations have been largely conducted by the ministries
responsible for trade or officials interested in supporting the domestic (or EU) financial
industry. This raises the question in how far countries liberalise financial services under
GATS to complement other financial reforms aiming at a more efficient and diversified
financial sector? “Trade [in the financial sector] should not be liberalised for trade’s
sake.”
62
The IMF and other international institutions have recognized that considerable and costly
capacity building is often required to educate regulators, supervisors, legislators and the
judiciary in order to create the appropriate framework for financial services. This means
that opening up financial services can only be successfully implemented when
accompanied by an orderly and well-designed policy and enough human and financial
resources. The IMF has a programme63 in place to monitor the reforms and the strength
of financial-sector regulation and supervision in many developing and emerging market
countries. But as the US representative put it during a WTO meeting of the WTO’s
Working Group on Financial Services, it is up to the negotiators of each country
concerned to deal with the issue themselves.
64
The EU requests also show little
coordination with the assessments of the IMF's programme. Developing countries wishing
to liberalise financial services could be fully using GATS exemptions and flexibilities, but
capacity to do so is often lacking.
GATS liberalisation provisions neglect wisdom gained after financial crises
Financial services liberalisation in line with all GATS rules and the 'Understanding'
disregards the global recognition after the Asian financial crisis that the stability of national
and international financial systems relies on the scale and sequencing of domestic
financial reforms. A gradual and considered approach to the deregulation of financial
services and financial flows is needed to make financial liberalisation beneficial for the
economy.
65
While the World Bank, IMF and Western countries argue that financial
services liberalisation increases financial stability and strengthens prudential soundness of
developing countries, they recognize that a well-sequenced capital account liberalisation
and domestic reform of the financial sector needs to be in place as well as appropriate
regulatory and adequate supervision. The financial crisis of 1997-98 has even convinced
the IMF that swift capital account liberalisation can lead to a financial crisis and that
sequencing of such liberalisation is necessary.
The setting up or acquisition of more establishments by foreign banks undermines
supervision by the host country while the lessons of the financial crises emphasise the
need for more transparency. Foreign banks might shift key decision-making and risk
management of their foreign establishments to the parent banks as is the case in
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 194
emerging market countries.
66
This reduces information available to host country
supervisors. Moreover, the Basel Committee (see chapter 5) agreed that the authorities of
the home country of the bank supervise foreign establishments of banks, especially
branches. Foreign supervisors might have ample experience in monitoring foreign
branches but are mainly interested in avoiding bankruptcy of the bank
67
and less
concerned about the needs of the country in which their banks operate. Although
cooperation between home and host country supervisory authorities does exist
68
,
experience has learned that regulators and supervisors of countries in which foreign
banks operate might not have all the information they need. Central bank officials have
recently called for better cooperation between supervisors in order to avoid risks by
liberalisation of financial services in emerging market economies.
69
6.2.5 Too little coordination between GATS negotiations and
international stability fora
There is a worrying deficit in concern about the GATS agreement in institutions which
have competence regarding international finance regulation and supervision. Only a few
(informal
70
) contacts and discussions have taken place between the GATS negotiators
and international institutions such as the IMF, the Basel Committee on Banking
Supervision, and the International Association of Insurance Supervisors. An EU official
claimed he had difficulties to draw the attention of international supervisors' bodies to the
GATS negotiations
The current GATS negotiations take place at a time when the reform of the international
financial system announced after the Asian financial crisis has bogged down while far
from finished. This underscores the importance of prudential measures and capital
account management at the national level. The problem is that national measures and
supervision might not be enough to deal with the effects of financial services liberalisation.
Financial conglomerates connect many financial markets worldwide.
In East Asia
71
, the increasing domination of Western financial firms in capital market
services, that connect East Asia with the global capital markets, would not be a problem if
there were enough prudential regulations at the global level. There is no effective system
of liquidity provision that should enhance the stability and efficiency of the global financial
system in which East Asian countries are embedded.
For developing countries, there is no effective mechanism of globally monitoring all
services and transactions by particular financial conglomerates that are operating in their
markets.
72
International mechanisms to deal with potentially destabilizing effects of
increased international capital movements by foreign firms are still weak and not involving
all countries.
No efforts to achieve more transparency in the financial services industry
Ironically, the GATS agreement makes greater transparency of government regulations
and decisions a priority (e.g. Art. III, VI.3., VII.4., VIII.3.- 4., X.2) but it does not address
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 195
the lack of transparency of financial conglomerates, which poses many problems to host
country financial authorities.
Improved transparency by operating internationally banks is a key issue in the reform of
the financial system. Lack of information about too much short-term foreign currency loans
is seen as an important cause of the financial crisis. Publishing more information should
increase “market discipline” in the financial markets because it allows investors and
customers to better assess the bank’s state of affairs and, presumably, to act accordingly.
In addition it opens up more opportunities to supervisory authorities to play their role. A
review of fifty-four international banks in 2001 showed that the required disclosure is still
unsatisfactory.
73
There is however nothing in the GATS agreement that requires
governments to impose more transparency from the (foreign) financial firms whose
ownership structures, services and transactions remain often hard to scrutinize for
developing countries.
Need for more input from developing countries
There are thus overlaps between the work of the WTO and work in other international
institutions regarding international financial stability and the reform of its architecture. It is
high time that the linkages and contradictions between the international and national
efforts for financial stability and the GATS rules are fully discussed in many fora, based
not on theory but on concrete experiences and situations in developing countries. Better
participation of developing countries in international supervisory and standard setting
bodies would enrich the discussion and, hopefully, cater for their needs. The aim should
be to avoid any unforeseen consequences with detrimental economic, social and
environmental effects, as was the case during the Asian crisis. Better insights in the risks
for financial instability might allow all developing country governments to take the
necessary accompanying actions within the GATS negotiations and outside, or to wait for
further market opening until they have defined their financial needs and established the
necessary mechanisms.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 196
6.3 Summary with conclusions and critical issues
1. Prioritizing swift liberalisation
Opening markets for foreign financial services and investment by foreign financial firms
has been a priority in past and current GATS negotiations. The limited provisions under
the GATS agreement to deal with the special nature and systemic risk of financial services
are subordinate to commitments to liberalise. The special appendix, the 'Understanding
on Commitments in Financial Services', in the GATS agreement even provides a model
for the swift and full liberalisation of financial services ensuring no trade barriers or
obstacles to profit making by foreign financial firms are left.
2. GATS fits neatly with the interests of the Western financial industry
The top financial industry lobby in the West has been very active during GATS
negotiations. The GATS agreement and current GATS negotiations fit neatly with the
expansion ("consolidation") and profit-making strategies of the top financial
conglomerates. In contrast, the GATS agreement has no provisions to strengthen
universal access to financial services nor to tackle ‘cherry picking’, improve the quality of
financial services to all customers, and increase financing opportunities for poorer
individuals and entrepreneurs. The GATS agreement does not link up with
intergovernmental declarations that promote sustainable development or poverty
eradication or with corporate social responsibility initiatives.
3. Increasing competition and concentration
Increased competition following further GATS liberalisation is likely to reinforce and orient
the financial industry toward high profit making, concentration and consolidation. The
GATS agreement only has weak instruments (art. IX) with which to tackle market abuse
and restrictive business practices that will follow concentration and consolidation.
There is no discussion within GATS on how far financial services concentration can go
and on when financial conglomerates should not become ‘too big to fail’.
The GATS agreement focuses on more transparency from governments but fails to
improve the transparency of the complex financial industry. GATS should compel all
signatories of GATS to legislate the transparency of financial firms operating in their
country. This would somewhat enhance fair competition.
4. GATS reinforces the gaps between rich and poor
The liberalisation of financial services is claimed to improve efficiency in the financial
industry and the economy. The experiences of liberalisation in developing countries show
that there is much more at stake than increased efficiency, choice of products and access
to capital.
Foreign financial firms widen the gap between rich and poor by targeting
the richest clients, the most developed regions and the best personnel
from their host countries.
This undermines the competitiveness and efficiency of developing
country banks that have more expertise to cater for the needs of the
poorer clients or to invest in the domestic industry.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 197
As soon as developing country governments open their markets, foreign
firms often rapidly take over a large part of the domestic financial
industry.
Due to rapid foreign expansion, host countries must spend additional
resources for regulatory and supervisory measures to handle changes
and risks.
Profits made off rich clients in poor countries are siphoned off to the
home countries in the North. GATS prevents government restrictions on
profit repatriation.
Foreign firms provide rich clients in poor countries with more
opportunities to channel their money to the North and invest in Western
companies.
Host country governments have less leeway in directing the development
of their domestic market, and have much less influence in integrating
sustainable development practices.
The EU has even been using the GATS negotiations to question
developing country measures that support poverty alleviation.
5. GATS increases the risks of financial crisis
The liberalisation of financial services as such poses many threats to the financial stability
of the host developing countries and the international system. GATS reinforces those
threats, and both limits and challenges governments anz central banks to develop
independent policy. While GATS is not supposed to liberalise capital flows, GATS
liberalisation of financial services in practice does.
What is worrying is that Western negotiators brush aside concerns raised by developing
countries while the risks of financial instability in developing countries are not fully
analysed or discussed. The negative consequences felt by the poor and the environment
due to liberalisation and GATS rules are so significant that reducing the risk of financial
crises is paramount.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 198
The risks to financial instability come from:
New financial services can have significant destabilizing effects on a
developing country’s financial system. Increasing cross-border capital
flows or risky financial strategies necessitate that the right regulatory and
supervisory systems be in place.
GATS articles promote cross-border capital movements and financial
instability by limiting government restrictions on profit repatriation and
capital flows related to committed (financial) services (see Articles XI.1.
en XVI (footnote 8)).
GATS rules permitting restrictions on unstable capital flows and
(financial) services are limited by many conditions. These conditions
prioritize the interests of foreign-service providers rather than the
capacity of a developing country to deal with problems in its financial
system.
The vagueness of financial prudential measures which GATS permits
leave many developing countries' regulations open to challenges by
WTO disputes, or bullying by the hardliners during the secret bilateral
GATS negotiations (the EU is doing this). The vagueness and questions
of GATS interpretation could result in countries refraining from
introducing national legislation for fear of future WTO disputes (i.e. the
Tobin Tax)
6. Limiting policy space
In countries where the domestic financial sector needs improvement or is not yet capable
of competing with foreign competitors, GATS articles XVI, XVII and VI limit the
government’s ability to make this a priority. Governments can set out exemptions to
GATS articles which would allow regulators and central banks to maintain their policy
space. However, the process to do so is complicated and difficult for some developing
countries to negotiate.
7. Trade negotiators prevail
Too little coordination between the trade negotiators and the institutions responsible for
the national and international financial system, is a problem in most countries. As a result,
especially western GATS negotiators ignore the experience of previous financial crisis.
Namely, the liberalisation of cross-border financial flows and financial services of
developing countries needs to be gradual and well sequenced; building capacity and
institutions to monitor the financial system is costly and takes time.
As well, lessons learned from the IMF Financial Sector Assessment Programme or other
financial scandals in the West (e.g. mismanagement of pension funds' capital) have not
informed the GATS negotiations. The latter continue without fully considering the
difficulties in regulating complex financial conglomerates.
8. Where are the International financial safeguards?
No adequate safety nets or international financial safeguards against the increasing
instability risks from GATS liberalisation exist. Some Northern countries have promoted
the use of international standards in the GATS. However, various southern countries feel
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 199
these standards do not address their needs as they were originally developed by northern
countries.
Better coordination between the GATS negotiations and the international financial stability
institutions is necessary but with the reforms of the global financial architecture far from
complete, it is most important to support capacity building and increased participation from
developing countries at all these fora.
9. Need to change direction
Ideally, the current GATS negotiations in financial services should be stopped.
A different negotiation model should at least include the international standard setting
bodies where developing counties have full representation, the UN and civil society
groups. The aim of the new model would be to ensure that the financial service sector
works for the poor and for small and medium business, and promotes sustainable
development and issues raised by corporate social responsibility initiatives.
Any form of liberalisation of financial services, which does not serve the needs of the poor
or does not promote sustainable development, is a dangerous strategy that increases
global inequalities as well as increasing global instability.
Requests for financial services liberalisation from the west on southern countries are
disproportionate and most countries economies’ are not ready to be fully liberalised.
There should be much more open public and political discussions to avert the risks
identified in this report and stop unfair requests by the West. No commitments should be
made during the bilateral GATS negotiations, unless there is a full guarantee by both
sides that the necessary safeguards are in place, nor should the West insist on any such
commitments in financial services.
If developing countries want to liberalise financial services under the GATS they should
not make further commitments unless they get major concessions during the WTO
negotiations in services and other areas so as to compensate for the risks of financial
instability, higher regulatory and supervisory costs and reduction in domestic financial
sectors.
1
See www.uscsi.org/groups/finLeader.htm
2
See for instance the EU requests on financial services to Chile, Thailand, Malaysia at
www.gatswatch.org; see also below in this chapter.
J
World Development Movement, Whose Development agenda?, April 2003.
4
ACLI, the largest trade association representing the US Life Insurers.
5
74% of the market in 1998-2001.
6
See: Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 160-204: even the Japanese banks had to retreat from their top
positions.
7
Frankfurter Rundschau, 31July 2003; see also above, chapter 2.
8
For an overview see for instance G. Bies, Financial liberalisation in Latin America, in Developing
countries and GATS, Ed. C. Jepma, E. Kamphuis, Universtiy of Groningen (EC 134), 2003, p. 57-65.
9
See: WTO, Communication from the People`s Republic of China - Assessment of Trade in Services,
document nr. 19, 21, 22. 26, 41, 43, 44 45, 47, 48, 49, 50; WTO, Report of the meeting held on 9
December 2002- 13 January 2003 (TN/S/M/5) 12 February 2003, document nr. 7.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 200
10
Only the issues of poverty eradication and lending have been added by the author of this report. The
issues raised by China have been illustrated by experiences found in the literature.
11
V. Murinde & M. Tefula, A foreign affair? How far does Africa need foreign banks? in Finance matters -
Finance liberalisation: too much too soon?, id21 Insights #40, March 2002 (at:
www.id21.org/insights/insighths40/insights-iss40-art02.html).
12
See for more examples: World Bank, Finance for growth: Policy choices in a volatile world, Policy
research report, May 2001: summary of the report, at
www.worldbank,org/research/interest/policyresrpt.htm
1J
H. Huizinga, S. Claessen & A Demirgüç-Kunt, How does foreign entry affect the domestic banking
market?, World Bank Working paper nr. 1918, June 1998: based on the experience of 80 countries
between 1988 and 1995; G. Bies, Financial liberalisation in Latin America, in Developing countries and
GATS, Ed. C. Jepma & E. Kamphuis, University of Groningen, 2003, p. 64: based on research in Latin
America.
14
M. Karatas & M. Broadbent, Foreign banks in emerging markets: a Turkish success story, in id21
Society & economy, 29 April 2003 (www.id21.org/society/s7amk1g1.html): Turkey is not considered to
be typical of emerging markets because foreign banks only control 2% of domestic banking operations
(in Poland they control 36%) and 40% is still in hands of large public banks. Twenty-one foreign banks
are operating in the country. The most successful foreign bank has first served multinational and
government clients and was able to survive the financial crisis in Turkey (high inflation, volatile market)
through adaptive and aggressive strategies and by segmenting the market amongst others to financing
of the many privatization projects, focusing on corporate banking and credit cards, limiting its physical
distribution network and careful selection of clients and sectors to which it provides services. In other
words, foreign banks have the ability carefully select the most profitable sectors and clients and are not
interested in full expansion all over the country, increasing the unequal development between the
different Turkish regions.
15
M. Vander Stichele, Liberalisation in Banking Services Does not Have the Stated Effects - Summary of
a case study of ABN Amro in Brazil, SOMO/Amsterdam, December 2001 (www.somo.nl).
16
Challenges for the South in the WTO Negotiations on Services - Summaries and Conclusions from
Three Case Studies: Health Care (Kenya), Electricity (Colombia), Tourism (India), edited by SOMO &
WEMOS, Amsterdam, January 2003 (see www.somo.nl).
17
See The Banker, Foreign banks must cherry-pick less to avoid Latin American wrath, January 3
rd
2005
18
J. Marchetti (WTO Economic Affairs Officer, Trade in Services Division), letter of 25th June 2003.
19
WTO, Committee on Trade in Financial Services, Report of the meeting held on 6 October 2003, nr.
29.
20
H. Huizinga, S. Claessen & A Demirgüç-Kunt, How does foreign entry affect the domestic banking
market?, World Bank Working paper nr. 1918, June 1998.
21
See: Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 166-167, 178-179
22
The percentages are based on the table 2 from A. Cornford, The WTO negotiations on financial
services : current issues and future directions, Paper for the Financial Markets Center, 2004, p. 10-
11: they exclude banking entities from Japan; only countries for which figures for 1996 en 2000/2001
were available in the tables have been used.
2J
Brunei, China (more than average increase: 171%), Hong Kong, Indonesia (more than average
increase: 414%), South Korea, Malaysia, Philippines, Singapore, Taiwan, Thailand, Vietnam; the
presence of Japanese banks are not included.
24
Argentina, Brazil, Chile, Colombia, Ecuador, Peru, Uruguay, Venezuela; (Mexico is excluded from
these figures but is known to host many foreign financial firms).
25
Albania, Bulgaria, Croatia, Czech Rep., Estonia, Hungary, Latvia, Poland, Romania, Slovakia ,
Slovenia.
26
A. Cornford, The multilateral negotiations on financial services : current issues and future
directions, 2003, p. 5, 11-12.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 201
27
Africa`s insurance industry needs assistance, in Addis Tribune, 7 June 2002.
28
V. Murinde & M. Tefula, A foreign affair? How far does Africa need foreign banks? in Finance matters -
Finance liberalisation: too much too soon?, id21 Insights #40, March 2002 (at:
www.Id21.org/InsIghts/InsIghths40/InsIghts·Iss40·art02.html).
29
G. Bies, Financial liberalisation in Latin America, in Developing countries and GATS, Ed. C. Jepma &
E. Kamphuis, University of Groningen, 2003, p. 64.
J0
H. Huizinga, S. Claessen & A Demirgüç-Kunt, How does foreign entry affect the domestic banking
market?, World Bank Working paper nr. 1918, June 1998.
J1
The capital account covers (among others) capital movements for investments while the current
account mainly covers (the payment of) imports and exports of goods and services.
J2
World Bank, Finance for growth: Policy choices in a volatile world, Policy research report, May 2001:
summary of the report, p. 4 at www.worldbank,org/research/interest/policyresrpt.htm
JJ
A. Cornford, The multilateral negotiations on financial services : current issues and future
directions, 2003, p. 20.
J4
Eichengreen, Toward a new international financial architecture: A practical post-Asia agenda,
Washington (Institute for International Economics), 1999, p. 48.
J5
J. Stiglitz, Lessons from Argentina's debacle, in Sand in the Wheels (ATTAC Weekly Newsletter), nr
113, 16 January 2002.
J6
Art. 7 and Art. 11.D.3. of the Understanding on Commitments in Financial Services. Ironically, in the
US, the Securities and Exchange Commission often scrutinises financial products before they are
introduced.
J7
The potential problems were discussed in different meetings of the Committee on Trade in Financial
Services held in 2003.
J8
WTO, Communication from the People`s Republic of China - Assessment of Trade in Services, 19
December 2002, document nr. 18- 49.
J9
WTO, Communication from the People`s Republic of China - Assessment of Trade in Services, 19
December 2002, document nr. 18-49.
40
Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 153
41
A. Cornford, The WTO negotiations on financial services : current issues and future directions,
Paper for the Financial Markets Center, 2004, p. 14.
42
Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 186
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L.R. Reynoso, Argentina: la justicia inhibida, la Argentina de pie, in Correos para la emancipacion, nr.
234, 12 February 2004.
44
Art. XI.1.: ” Except under the circumstances envisaged in Article XII,"(see further below) "a Member
shall not apply restrictions on international transfers and payments for current transactions relating to
its specific commitments."
45
Yun-Hwan Kim, Financial opening under the WTO Agreement in selected Asian countries: progress
and issues, Asian Development Bank, Economic and Research Department, Working Paper No.24,
September 2002.
46
On the basis of his personal assessment for the activities in the Annex on Financial Services an IMF
observer attributes “major importance “ to “capital flows for virtually all financial services delivered
through mode 3 (commercial presence), as such presence by its nature implies some form of cross-
border investment”. Indeed, the only activities under the heading of banking and financial services
(excluding insurance) to which he does not attribute such importance are financial leasing, provision
and transfer of financial information, and advisory, intermediation and other auxiliary services. See
A.Kireyev, Liberalization of trade in financial services and financial sector (analytical approach), IMF
Working Paper WP/02/138, August 2002, pp. 10-14.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 202
47
See WTO - Committee on Trade in Financial Services, Report of the meeting held on 2 December
2002; IDEM, Report of the meeting held on 26 February 2003.
48
A. Cornford, The WTO negotiations on financial services: current issues and future directions, Paper
for Financial Markets Center, [2004], p. 6.
49
WTO, Committee on Trade in Financial Services, Report of the meeting held on 1 December 2003, part
D.
50
WTO, Committee in Trade on Trade in Financial Services, Report of the meeting held on 6 October
2003, part D.
51
See www.gatswatch.org
52
WTO, Communication from Malaysia: Challenges in the financial services sector, 30 July 2003 (WTO
document TN/S/W/17 S/FIN/W/28) discussed at meetings of the WTO Committee on Trade in Financial
Services held on 7 July and 6 October 2003
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See www.gatswatch.org: EC requests to Malaysia, Financial services, p.3.
54
M. Metzger (BIF Berlin), letter of 11 December 2003.
55
Tax havens seek WTO intervention, in FT, 2 October 2 2000.
56
Friends of the Earth - US, Sustainability and accountability in the financial services sector, declaration
released in January 2003, p. 3.
57
M. Queisser, Pension reform: lessons from Latin America, OECD Development Centre Policy Brief, nr.
15,1998, see also H. Reisen, Liberalization foreign investment by pension funds: positive and
normative aspects, OECD Development Centre Technical Paper nr. 120, January 1997.
58
For instance: the Basel Committee on Banking Supervision, the International Association of Insurance
Supervisors (IAIS), International Organisation of Securities Commissions (IOSCO) and the Joint Forum
on Financial Conglomerates. The Financial Stabiltiy Forum has classified 12 international financial
standards as key standards for financial stability. Developing countries are not always well represented
in these international bodies whose standards might not always be fully adequate in developing
countries. For further explanation: see chapter 5.
59
The IMF Financial Sector Appraisal Programme (FSAP): the programme assesses the vulnerabilities of
a country's financial sector and actions to be undertaken.
60
Alexander Kern, The World Trade organisation and financial stability: the need to resolve the tension
between liberalisation and prudential regulation, ESRC Centre for Business Research Cambridge
University (Working Paper No.5), 2002, p. 5, 45.
61
A. Cornford, The WTO negotiatins on financial services : current issues and future directions, Paper
for the Financial Markets Center, 2004.
62
N. Tamirisa et.al., Trade policy in Financial Services, IMF Working Paper N0.31, 2000, p.12.
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The IMF`s Financial Sector Assessment Programmes (FSAPs) monitor domestic financial sectors in
developing countries and provide technical assistance to strengthen them. The IMF's has also been
monitoring and assisting the liberalization of capital accounts which has been seen as one of the
problems leading to the Asian financial crisis.
64
WTO, Committee on Trade in Financial Services, Report of the meeting held on 26 February 2003.
65
Finance matters - Finance liberalisation: too much too soon?, id21 Insights #40, March 2002 (at:
www.id21.org/insights/insighths40/insights-iss40-art00.html); see also: World Bank, Finance for growth:
Policy choices in a volatile world, Policy research report, May 2001.
66
BIS, Foreign direct investment in the financial sector of emerging market economies, Report submitted
by the Working Group established by the Committee of the Global Financial System, March 2004, 1-2.
67
Basel Committee on Banking Supervision, Principles for the Supervision of Banks’ Foreign
Establishment, May 1983, Art. IV: this is the basis of supervising establishments abroad, called the
‘Concordat’ and replaces the first version of 1975.
68
Basel Committee on Banking Supervision, Information flows between banking supervisory authorities,
April 1990: is an addition to the Concordat because there was not enough cooperation (possible)
between supervisors of home and host countries.
Critical Issues in the Financial Industry
Chapter 6 – Trade in financial services 203
69
BIS, Foreign direct investment in the financial sector of emerging market economies, Report submitted
by the Working Group established by the Committee of the Global Financial System, March 2004, 1-2.
70
See WTO, Committee on Trade in Financial Services, Report of the meeting held on 7 July 2003,
(S/FIN/M/41), nr. 2: an informal meeting took place between (the chair of ) the Committee on Trade in
Financial Services and the Basel Committee on Banking Supervision and the International Association
of Insurance Supervisors on 27 June 2003 but members of the Committee would be briefed about the
visit in “informal mode” by the chair (as agreed during the previous Committee meeting held on 16 May
2003).
71
Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 185: East Asian policy makers regret that there is:
- no reliable global or regional lender of last resort
- no agreement among the global community to establish a global regulatory authority
- not enough effort to expanding and strengthening cross-border financial supervision and regulation by
advanced countries with developed financial markets
- an absence of effective cross-border prudential supervision of foreign financial companies operating
out of East Asian financial markets.
72
Yung Chul Park, Kee Hong Bea, Financial liberalisation and integration in East Asia, in Financial
stability and growth in emerging economies - The role of the financial sector, Ed J.J. Teunissen & M.
Teunissen , The Hague, 2003, p. 185-186; see also activities of the Joint Forum on Financial
Conglomerates.
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See chapter 5: only 63% of the items considered important by the Basel Committee of Banking
Supervision (the association of major supervisory authorities). While that was an improvement over the
previous years, it was still far from sufficient. In particular, information about their techniques for
mitigating credit risks (including more speculative credit derivatives) was lacking, which makes it
difficult to monitor from the outside their practices and expertise for avoiding bad loans, a major source
of (in)stability
The need for more transparency became clear during the financial crisis in South East Asia in 1997-98.
There was too little oversight that foreign banks had been giving too much short term foreign currency
loans.
Critical Issues in the Financial Industry
Annexes 204
Annexes
For the annexes and more information about the financial sector and financial
corporations see our website: www.somo.nl, look for <file> financial sector.
Annex I:
UNEP Statement by Financial Institutions on the Environment & Sustainable
Development
See http://www.unepfi.org/signatories/statements/fi/
Annex II:
The "Equator Principles"
See http://www.ifc.org/ifcext/equatorprinciples.nsf/Content/ThePrinciples
Annex III:
CEO’s and Chairmen statement of companies operating in the financial sector of
WBCSD
See http://www.wbcsd.ch/DocRoot/5PV72pFXVXcIqJX88UlC/20020925_finance.pdf
Annex IV:
The Collevecchio Declaration on Financial Institutions and Sustainability
See http://www.foe.org/camps/Intl/declaratIon.html
Annex V: NGO
Collective Analysis of the Equator Principles
See http://www.globalpolicy.org/socecon/ffd/2003/06ngos.htm
For a summary of the main points see http://www.ran.org/news/equator_ngo.html
Annex VI:
UNEP Statement of Environmental - Commitment by the Insurance Industry
See http://www.unepfi.org/signatories/statements/ii/
Annex VII:
Gri financial services sector supplement on social performance (November 2002)
See http://www.globalreporting.org/guidelines/sectors/GRIFinancialServices.pdf
doc_902445295.pdf