Risk in Financial Conglomerates: Management and Supervision

IN THE PAST DECADE we have seen financial conglomerates gain in importance. Financial conglomerates are groups that combine banking, securities, and insurance activities within one organization. ¹ Trends such as disintermediation, globalization, and deregulation have made cross-sector consolidation possible. Consolidation has been driven by the search for revenue enhancement and cost savings and has been encouraged by improvements in information technology. So far most consolidation has been within sector and country. Nevertheless, some cross-sector groups of impressive size have been formed. An example is the ING Group, whose balance sheet at the end of 2001 equaled a little more than €705 billion. Although the external risks facing financial firms have not changed in essence, combining different activities within one organization presents new challenges both for the group's management as well as for regulators. In this paper we discuss the most important issues in this area.

After outlining the developments that have led to the formation of large, complex, and diversified financial firms, or in other words financial conglomerates, we discuss the reasons that have been cited, mainly in the academic literature, for regulatory intervention, covering banking, insurance, and financial conglomerates in turn. Sheer size by itself, after all, does not merit the extensive regulation to which financial firms are subject. The reasons cited for banks are the possibility of bank runs, systemic crises, and moral hazard due to a lender of last resort and concerns regarding consumer protection. For insurance firms, the main reasons are concerns regarding consumer protection and, more generally, financial stability.

Given the good reasons that exist for regulation and supervision, within what institutional framework does this take place? Consolidation in the financial sector, for instance, would require closer coordination of regulation across the banking, securities, and insurance sectors. In the fourth section of this paper, we describe the—European—framework, with special attention to the Dutch situation. Since financial conglomerates were formed relatively early in the Netherlands, the regulatory response had to be formulated ahead of the curve as well. We highlight the motivations that played a role in creating the present Dutch regulatory structure.

Regulators are not the only stakeholders interested in the risk profile of financial firms. Many firms commit sizable resources themselves to monitor and manage risk. However, received wisdom is that in the absence of market imperfections, risk management does not add any value. The reasons for managing risk are thus based on violations of the assumptions of the Modigliani-Miller irrelevance theorems. We discuss the most important digressions in turn. Given that both management and regulators are interested in the risk profile of financial firms, they have a shared interest in accurate measurement and, consecutively, management of risk. We then briefly outline measurement methods, primarily to discuss the most important hurdles that have to be taken before a firm-wide risk management system can be implemented adequately.

Finally, we discuss the interplay between the objectives of supervisors and the goals of financial conglomerates. Are these objectives in line with each other, or are there areas in which opposite interests are evident? In what way can supervisory regulation support the developments of firm-wide risk management systems, and is this beneficial to the industry? The main issue addressed is what the framework for coming to an adequate risk management process, and thus a satisfactory level of capital, should look like. The central tenet here is the supervised institution's responsibility in this area. The concluding section summarizes our findings.

The Rise of Financial Conglomerates

An obvious definition of a financial conglomerate is a group of firms that predominantly deal with finance (that is, banks). In financial regulation, however, it has acquired a slightly different meaning: a financial conglomerate has come to mean a group of firms that engage in financial activities that have been kept separate, by law and regulation, for many...